The largest overhaul of the nation’s financial system since the Great Depression became law on July 21 when President Barack Obama signed the 390,000-word Dodd-Frank financial regulatory bill.
The bill passed on overwhelmingly partisan lines, with only three Republicans in the House and three in the Senate voting for it. It became known as the Dodd-Frank bill as Sen. Chris Dodd (D-CT) and Rep. Barney Frank (D-MA) shepherded it through their respective legislative chambers.
The law directs regulators to create hundreds of new rules on everything from debit cards to hedge funds to mortgage underwriting. It gives the government new powers to identify risky institutions and shutter them via a new systemic regulator. It forces banks to keep more capital on hand, bans them from making trades on their own behalf, and sharply limits their ability to invest in vehicles like hedge funds.
In addition, it creates a new consumer financial protection bureau with the power to create and enforce new rules regarding financial products such as home-equity loans and credit cards.
Divided on Merits
Unions characterize the measure as a big win.
“For years, big banks have profited on the backs of working families,” said AFL-CIO President Richard Trumka in a statement. “After the financial meltdown brought on by Wall Street’s greed and irresponsibility, it would have been an outrage for the status quo to stand.”
Employer groups say the bill will hurt all workers.
“Our nation’s unemployment still hovers close to 10 percent, and manufacturers face ever-growing challenges as we emerge from this recession. This legislation will only add more costs and have a negative impact on those who had nothing to do with the financial crisis. We need to focus on policies that will grow our economy and enable job creation,” said John Engler, president and CEO of the National Association of Manufacturers, in a statement
Clearinghouse Collateral Debated
Financial derivatives are often cited as having contributed to the financial crisis, and one mandate in the bill requires certain categories of derivatives to be traded through clearinghouses. Proponents claim it will remedy what they see as a problem in over-the-counter (OTC) derivatives trading: with derivatives being traded privately instead of through a central exchange, the default of a major counterparty could scare away traders and drain liquidity from a market. Over-the-counter trading does not have a central counterparty (i.e., the exchange) to guarantee the transaction.
Supporters of the clearinghouse measure want to require brokers to post collateral so that the clearinghouse could cover any defaults and clear all trades even in the event of counterparties becoming insolvent. Opponents note this requirement will increase transaction costs for brokers, sending many traders to foreign brokers not subject to the new rule.
In addition, as Mark Roe of Harvard Law School noted in a column for The Wall Street Journal, “If trillions of dollars of derivatives trading goes through a clearinghouse, we will have created another institution that’s too big to fail.”
Fannie, Freddie Unscathed
Two major players in the housing bubble that sparked the financial crisis are untouched by the new legislation: Fannie Mae and Freddie Mac, the government-sponsored enterprises created by Congress to promote home ownership. Harvard University economics professor Jeffrey Miron notes the law “does nothing to reform—i.e., eliminate—Fannie Mae and Freddie Mac, two central factors in the recent crisis.”
The bill adds huge new regulatory bureaucracies to the nation’s capital markets, but economist Mark Thornton of the Mises Institute said, “Government regulation only gives the appearance of consumer protection and encourages consumers to let down their collective guard.”
Skewing the Market
Section 113 of the bill institutionalizes the concept of “too big to fail,” says James Gattuso of the Heritage Foundation. A new board called the Financial Stability Oversight Council (a council of already existing regulators) is “charged with identifying firms that would ‘pose a threat to the financial security of the United States’ if they encounter ‘material financial distress’,” Gattuso notes.
Firms counted in this category would be able to borrow more cheaply than their smaller competitors because, like Fannie and Freddie before them, implied government backing would make them seem more stable and attractive to lenders. That means the bond market would be pressed to reward sheer size instead of competitiveness.
Peter J. Wallison of the American Enterprise Institute explains, “The real significance of the too-big-to-fail designation, as every small banker knows, is that the implicit protection of the government confers a lower cost of funds and thus significant competitive advantages.”
On the Enterprise blog, Wallison wrote, “The market will see immediately that the government has created Fannie Maes and Freddie Macs in every sector of the financial system.”
Bureaucracy to Come
The bill also mandates dozens of studies to be conducted in coming months, the results of which will be used by federal agencies to issue rulemakings.
In a recent release to its clients, the law firm of Davis, Polk, and Wardwell estimated the bill will require a minimum of 243 bureaucratic rulemakings. The firm needed 150 pages simply to explain what The Wall Street Journal called the “bureaucratic ecosystem created by Dodd-Frank.” The U.S. Chamber of Commerce estimates the law will require 520 rulemakings, 81 studies, and 93 reports.
Because the law leaves large portions of its provisions open to further interpretation and rulemaking, nobody fully understands what the full effects will be.
Toby Kearn ([email protected]) is a research assistant for the Commerce, Insurance, and Economic Development Task Force of the American Legislative Exchange Council in Washington, DC.