Charging Forward

After the most devastating financial crisis since the Great Depression, $885 billion in bank losses, and 13 months of congressional wrangling, we finally have a financial reform law on the books. Does it do the trick?

By James Surowiecki

Fall 2010

In November of 2008, with the U.S. economy in the grips of the worst financial panic since the Great Depression, incoming White House Chief of Staff Rahm Emanuel told attendees at a Wall Street Journal conference: “You never want a serious crisis to go to waste.” He used quick hand gestures to drive home the importance of his point, adding that the financial crisis could provide an opportunity to do things that in the past seemed impossible.

To be sure, when it comes to addressing a troubled U.S. financial system, the only time Washington has shown much interest in real reform has been in the wake of crisis. The Federal Reserve Board, for instance, was created in part as a reaction to the meltdown of 1907. The Great Depression led to federal deposit insurance, the Glass-Steagall Act, and a complete revamping of securities regulation. And the combination of the late-1990s stock market bubble and an epidemic of corporate fraud at companies like Enron and WorldCom gave us the Sarbanes-Oxley Act.

Now, nearly two years after Emanuel’s pronouncement, and only a few months before the two-year anniversary of Lehman Brothers’ bankruptcy filing, the Obama administration has pushed a major financial reform bill through Congress, one that will bring about the most substantive and far-reaching transformation of the American financial regulatory system since the 1930s.

The good news, then, is that this crisis did not go to waste. The new law limits banks’ proprietary trading and the amount of capital they can commit to things like hedge funds. It moves most derivative trading to open exchanges and requires clearinghouses for derivatives trades, which will increase transparency in an opaque market, and gives regulators more power to restrict the amount of leverage banks use. Most importantly, the law creates a new consumer financial protection agency intended to limit the kind of predatory and often fraudulent lending practices that became ubiquitous during the housing bubble, and gives the government “resolution authority”—the power to take over and wind down major financial institutions the way the FDIC can take over insolvent banks. That, in principle, will make future bailouts less likely and reduce the amount of moral hazard in the system.

The bad news is that it is unclear whether enough has been done to stop the next crisis before it happens.

“Where the law puts us is far better than where we were,” says Harvey J. Goldschmid, former SEC commissioner and Columbia Law School’s Dwight Professor of Law. “But there was an immense opportunity for reform, and I don’t think Congress has done as much as they could have done.”

If you were grading on a curve, measuring this law against typical Washington standards, it would probably get a good grade. But if you measure the new law according to what the financial system needs, you probably would have to give it something closer to a “pass,” or perhaps even an “incomplete.” Even though it is more than 2,000 pages long, there are a surprising number of big, systemic problems that the law does not even attempt to address.

“A lot of what’s in the law is directed at things that didn’t really have all that much to do with the crisis,” says Jeffrey N. Gordon, the Alfred W. Bressler Professor of Law. “At the same time, it doesn’t actually do much about some of the things that had quite a lot to do with the crisis. The mortgage-backed securities market and the explosion in the number of financial instruments, like CDOs [collateralized debt obligations] and CDOs squared, for instance, were central to what happened, but the law doesn’t really touch them.”

Nor does the law do anything about Fannie Mae and Freddie Mac, the two huge mortgage lenders that the government took over in September 2008. Those companies have now racked up hundreds of billions of dollars in losses on mortgages, and the government has extended them, in effect, an open credit line. “Fannie and Freddie remain time bombs waiting to explode,” says John C. Coffee Jr., the Adolf A. Berle Professor of Law. “But Congress didn’t know what to do about them, and so it did nothing.”

Similarly, the law does nothing about reforming money-market funds, an issue that Gordon has written on extensively. Money-market funds have become a huge part of the financial system, with trillions of dollars under management, and investors now treat these funds as risk-free investments. (Putting your money into a money-market fund is seen by most people as the same as putting it into a bank.) As a result, if a money-market fund gets into trouble—as happened in the wake of Lehman Brothers’ failure, when one fund “broke the buck”—the government is practically obliged to step in to avert panic. “These funds are a huge, gaping hole in the regulatory system,” says Gordon. “They’ve been the source of many of the troubles we’ve had over the years, dating back to the S&L crisis. And, as we saw in the fall of 2008, they can end up amplifying systemic risk. Yet they’re subject to very little supervision, and this law doesn’t change that.”

Even on issues
where Congress did act, the law’s solutions are often cautious. The rule limiting banks’ proprietary trading, which was inspired by former Fed Chair Paul Volcker, was originally more ambitious. “There was much to like about Volcker’s approach,” says Harvey Goldschmid. “His concept was: ‘Let’s make commercial banking dull again—if the government is going to back up commercial banks, the amount of risk they can take should be limited.’ There were tough technical questions involved in this, but I think that it could have been done more effectively, and that we could have had tougher rules than the ones we got.”

The new law is similarly timid when it comes to reforming executive compensation. While it mandates that shareholders be given a “say on pay” (the chance to cast a non-binding vote on companies’ executive compensation arrangements), Congress didn’t require that shareholders get that say annually, as many had recommended. (Shareholders will get the right to choose whether to vote on pay every one, two, or three years.) More substantive reforms of executive compensation at financial firms, meanwhile, were not really considered, even though executive compensation practices at these firms helped exacerbate the financial crisis. Jeffrey Gordon, for instance, has written a paper titled “Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity-Based Pay,” which argues that paying financial company executives solely in company stock actually magnifies the problem of systemic risk. In such situations, he writes, executives (like, say, Lehman Brothers’ Richard Fuld) are interested only in what happens to their company, and this leads them to ignore the ripple effects of their actions, to the detriment of everyone else. “In ordinary times, paying people in stock does what it’s supposed to do—align the interest of management and shareholders,” Gordon says. “But when a financial firm gets into serious trouble, the incentives go haywire. Diversified shareholders, who are invested in lots of different companies, want to keep the system stable. But the executive with large stock holdings may care almost exclusively about protecting equity’s interests and thus may be reluctant to raise new capital or sell the firm, which could severely dilute the equity. We ordinarily think someone like Dick Fuld, who had so much of his net worth tied up in Lehman stock, would be the best person to be running the company, but he was actually the last person you wanted running Lehman in the summer of 2008.”

What we need, Gordon argues, is a more sophisticated system of executive compensation for financial firms, one that takes into account the reality of systemic risk. But such an idea was not even on Congress’ radar. And that lack of imagination is, in a sense, perhaps the biggest problem with the financial reform law.

Halfway measures also characterized Congress’ approach to reform of the credit-rating agencies, such as Moody’s and S&P, whose inflated ratings on mortgage-backed securities encouraged investors to pour trillions of dollars into the housing bubble. Because these companies are paid by the people issuing the securities they rate, they have an incentive to defer to the issuer and underwriter. Because they have been insulated from liability, their incentives to engage in due diligence or any fact-checking are minimal. And because their ratings are government-sanctioned, they have inordinate influence over investor decisions. Reforming the current “issuer pays” business model is the most important step, John Coffee argues. “If you get the incentives right, you don’t need all that much regulation,” he says. “If you get the incentives wrong, it’s not clear that any amount of regulation will solve the problem.”

But this task remains incomplete. Although the Senate bill contained a provision proposed by Senator Al Franken that would have created an independent board to choose the rating agency to give the initial rating on structured finance offerings (so that the issuer could not select its own rater), the final legislation deferred a decision on this proposal for two years and effectively gave the decision to the SEC. Coffee helped draft the new liability provisions for credit-rating agencies and notes that the goal was less to impose high liability than to induce the rating agencies to do due diligence and play the role of a traditional gatekeeper. “The unique thing about the rating agencies up to now is that they’ve faced little competition and no liability, and have done no factual verification,” Coffee says. “The result was GIGO—Garbage In, Garbage Out. After [the] Dodd-Frank [legislation], they may face some competition, and they’ll have some liability, but not an extraordinary amount. However, they will have an obligation to do some fact-checking. So it’s not rearranging the deck chairs on the Titanic, but we haven’t really yet changed the incentives.”


While dealing with the credit-rating agencies was important, dealing with so-called “systemically important institutions”—those banks that are too big, or too connected, to fail—was the law’s essential task. And it does represent a real improvement on what we had before: Resolution authority makes it possible, in theory, for the government to take over a big bank and wind it down, which in essence means it is now possible for a big bank to fail without wreaking the havoc that Lehman Brothers’ bankruptcy caused. This is very much a good thing. But there’s a catch: While the new law creates a resolution authority, it does not pay for it, and winding down an institution isn’t cheap. It requires a substantial outlay of cash in the short term. The question is: Where is that money going to come from?

“You can deal with the problem of a failure of a systematically significant financial institution either ex ante or ex post,” John Coffee says. “The better approach is to do it beforehand, raising the money via a bank tax based on the size and riskiness of a bank’s liabilities. That creates a fund so that, in effect, the industry is paying up front for any future bailout of its members.” Jeffrey Gordon, similarly, argues that “prefunding” is the right approach and, in a recent article co-authored with Christopher Muller, called for the establishment of a $1 trillion Systemic Emergency Funding Authority. That would ensure the government had enough resources to deal with even a severe crisis, and would reduce the uncertainty that can actually make crises worse than they otherwise would be.

As it happens, Congress initially embraced the idea of a prefunded resolution authority—although not one on the scale Gordon called for. The House bill established a $150 billion fund, while the Senate originally contemplated a $50 billion fund. But after congressional Republicans began referring to the provision as a “bailout fund,” the idea was dropped. Now, the money to pay for the resolution authority will have to come from the government up front, and then will be recouped via a bank tax after the fact. This is not necessarily disastrous. But it does make the whole process much more uncertain. “Regulators will be strongly tempted to postpone taking over a failing financial firm to avoid recourse to taxpayer funds,” Gordon says. “Moreover, exclusive reliance on the resolution process in a financial crisis could easily lead, through a series of falling dominos, to nationalization of much of the financial sector. Yet regulators are given no discretion to employ alternative means of systemic support, unless they go to Congress mid-crisis. If the job is to prevent a systemic crisis, this setup makes the regulators’ job much harder. It’s paradoxical: We’re trusting the regulators and giving them tremendous authority, yet at the moment when the crisis happens, we’re depriving them of the tools they need.”

What this means, really, is that it is very difficult to know how (or if) resolution authority is going to work in practice. And that uncertainty is characteristic of the law as a whole: Despite its enormous length, it leaves a great deal about the new rules of the financial road undefined, outsourcing to regulators much of the responsibility for writing them. As Harvey Goldschmid says: “We’re really giving an awful lot of authority to the regulators, and you’ve just got to hope they will use it wisely.”

In the case of corporate governance, for instance, the law gives the SEC the authority it needed to allow big shareholders to get proxy access to nominate dissident directors, a move that Goldschmid says represents “a major step forward.” But how that authority plays out in practice will depend on what the SEC does—now and in the future.

To some degree, of course, this scenario was both inevitable and desirable: Regulators have, in theory, more knowledge and experience than legislators, and the law may be too blunt an instrument to deal with all the complexities of the financial system. In addition, even when a statute is written, it is up to regulators to interpret and enforce it. There is no getting around, in other words, our reliance on regulators’ good judgment. The problem is that, as recent history has demonstrated all too vividly, regulators are subject to the same kind of boom-and-bust cycles that investors are—going through periods when they take their supervisory tasks very seriously and are keenly aware of the potential problems that exist, and other periods when they are far less vigilant. And these cycles are shaped also by ideology: Over the last couple of decades, with some exceptions, regulation has more often been seen as unnecessary than as useful.

What is hard about reaching a final judgment on financial reform, in other words, is that so much of what will happen will depend on what regulators do. “The greatest danger in the future is what you might call the sine curve of regulatory intensity,” says Coffee. “In the period after any crash, regulators get tough, but as things move back toward normalcy, there’s a tendency to step back. Regardless of what’s happening right now, we know that we will eventually see the failure of a systemically significant institution. The question is whether regulators will then have the authority and will to act.”

James Surowiecki is a staff writer at The New Yorker, where he writes “The Financial Page.”

Illustration by James Steinberg