Regulating Wall Street

The Dodd-Frank Act and the New Architecture of Global Finance

Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, Ingo Walter, Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, Ingo Walter

• Publisher: Wiley
• Year: 2010
• Print ISBN:
  9780470768778
• Edition: 1
• eBook ISBN:
  9780470949863
• Topic: Business
• Subtopic: Finanza
• Index: Business

Experts from NYU Stern School of Business analyze new financial regulations and what they mean for the economy

The NYU Stern School of Business is one of the top business schools in the world thanks to the leading academics, researchers, and provocative thinkers who call it home. In Regulating Wall Street: The New Architecture of Global Finance, an impressive group of the Stern school's top authorities on finance combine their expertise in capital markets, risk management, banking, and derivatives to assess the strengths and weaknesses of new regulations in response to the recent global financial crisis.

• Summarizes key issues that regulatory reform should address
• Evaluates the key components of regulatory reform
• Provides analysis of how the reforms will affect financial firms and markets, as well as the real economy

The U.S. Congress is on track to complete the most significant changes in financial regulation since the 1930s. Regulating Wall Street: The New Architecture of Global Finance discusses the impact these news laws will have on the U.S. and global financial architecture.

Part One

Financial Architecture

Chapter 1

The Architecture of Financial Regulation

Thomas Cooley and Ingo Walter*

There are four pillars of effective regulatory architecture that are common across all financial systems. Good architecture should (1) encourage innovation and efficiency, (2) provide transparency, (3) ensure safety and soundness, and (4) promote competitiveness in global markets. Efforts to pursue these objectives at the same time inevitably create difficult policy trade-offs. Measures that assure greater financial robustness may make financial intermediation less efficient or innovative, for example. Efforts to promote financial innovation may erode transparency, safety, and soundness. Competitive pressure among financial centers may trigger a race to the bottom in terms of systemic robustness to internal and external shocks.

Unfortunately, benchmarks underlying the financial architecture, on which it is easy to find agreement, are far more difficult to define in detail—and even more difficult to calibrate in practice. We know that excessive regulation involves costs, but what are they? We also know that underregulation can unleash disaster, which can be observed only after the fact. So optimum regulation is the art of balancing the immeasurable against the unknowable. It is not surprising that financial crises are a recurrent phenomenon.

In this chapter we spell out the practical alternatives for financial regulation and identify the nature of their impact on key attributes of financial products, markets, and firms. We then narrow the range of regulatory options to those contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and comparable regulatory initiatives around the world, and assess them in light of the four pillars of regulatory architecture underlying a financial system that successfully serves the public interest.

1.1 WALKING THE REGULATORY TIGHTROPE

The Prologue to this volume makes clear that financial intermediation is an essential economic activity that is fraught with difficulties. There are frequent market failures involving asymmetric information, costly state verification, and missing markets. Even in the simpler world of the early twentieth century, such problems brought the financial system to its knees repeatedly until a more robust regulatory structure—one that somehow managed to work tolerably well for a long time—was designed in the 1930s. Over the ensuing decades that structure was altered to accommodate new institutions, new financial instruments, financial globalization, and periodic shocks and market failures. Over time it began to resemble a structure that had been modified too many times and in too many ways to efficiently accommodate the growing complexities of modern financial intermediation. Eventually it reached a tipping point and failed spectacularly, with huge costs to the global economy.

Although the worst of the financial crisis of 2007 to 2009 has passed, the defects of the dominant institutions remain. They continue to pose grave risks to future financial stability. So a new regulatory architecture has become inevitable, and it is important to consider how it will perform.

Regulatory architecture is critical to resource allocation and economic growth. Economies with inefficient financial systems demonstrably waste more economic resources and grow more slowly than otherwise comparable economies with efficient financial systems. Economies with weak financial systems continue to plug into global financial markets in search of low-cost capital, so they are no longer immune to global shocks and sometimes contaminate the system with shocks of their own. Good financial architecture has to be robust to shocks that emanate from the financial system and the real economy both domestically and internationally.

Adding yet another layer of complexity are the institutions charged with executing regulatory mandates affecting the financial architecture. Should regulators be organized by function—such as commercial banking, investment banking and financial markets, asset management, and insurance—allowing them to gain enough industry expertise to have a reasonable understanding of what it is they are regulating? Or should they be structured in line with the firms they are regulating, ranging from financial conglomerates to community banks, so they can better oversee the complexities and avoid overinvestment in regulatory infrastructure where it isn't needed?

And who should monitor the buildup of systemic risk in the financial structure as a whole (macro-prudential risk), which goes well beyond the remit of regulators covering individual firms (micro-prudential risk)? This in turn raises the question of who gets to determine when firms have failed, and how to resolve them if they are no longer viable? And should those doing the resolving be the same people who created the failure or stood by and watched it happen in the first place?

In great architecture, “form follows function.” Financial architecture is really no different. The institutional structure that should be created to implement the regulatory changes that have now been passed into law in the United States depends critically on certain macro decisions about the goals of the regulation. If some activities are carved out of financial conglomerates into independent financial specialists, for example, a sensible regulatory architecture may be very different from what would be needed if financial conglomerates are left intact, with all of their internal complexity, conflicts of interest, and opaqueness.

Finally, there is the critical issue of regulatory execution, which is almost always done by high-minded and overworked civil servants standing against the best and the brightest on the payrolls of those they are supposed to be regulating. Plenty of examples attest to the inequality of this battle, with well-intentioned regulation undermined by regulatory arbitrage that distorts its purpose and implementation.

There are many regulatory issues at stake. How do we protect consumers? What should we do about corporate pay? What should we do about mortgages? How should we regulate derivatives? And so on. All are important to someone, but there is one issue that is important to all: How do we construct a system of regulation in which decisions made in one or a few financial institutions cannot bring the entire system to a halt and the world's economies to their knees? This is the problem of containing systemic risk. Without question it is the single most important issue.

The U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the discussions being held elsewhere in the G-20 countries are at least in part a reflection of popular sentiment—notably a powerful emotional antipathy toward bankers—lobbying by special interests, and substantial political trade-offs and maneuvering. But that is the history of both our financial system and financial regulation. Here our goal is to offer informed commentary on the new structures for financial regulation that are on the table, and an idea of what might be done better. Since regulation and government intervention are an explicit acknowledgment of market failure, there is an inherent acceptance of the cliché that we should not let the perfect be the enemy of the good.

The regulatory dialectic in the financial services sector is both sophisticated and complex, and it often confronts heavily entrenched and politically well-connected players—and runs up against the personal financial interests of some of the brightest minds and biggest egos in business. The more complex the industry, the greater the challenge to sensible regulation, probably nowhere as strikingly as in the case of massive, complex, global financial services conglomerates that may be too hard to manage, too hard to oversee and govern, and almost certainly too hard to monitor and regulate.

To preview our line of thinking, we believe that by far the best way to address the most important issue of all—systemic risk—is to make the firms that create it pay a fair price for having created it. This requires measuring, pricing, and taxing systemic risk, as discussed in detail in Chapters 4 and 5 of this book. The only alternative is to require institutions that manufacture systemic risk to become simpler by separating their excessively risky activities into independent firms, as discuss in Chapter 7.

Whether derisking the financial system by correctly pricing systemic risk or by segregating highly risky functions into nonsystemic firms, a powerful regulatory capability is essential. The financial crisis of 2007 to 2009 has highlighted the failure of other approaches—such as managerial self-regulation, proper corporate governance, industry self-regulation, and market discipline—to successfully contain systemic risk. It is far too late for the financial industry to argue that lessons have been learned that ensure that firm-level and system-level risk management will work better next time.

1.2 ALTERNATIVE APPROACHES TO FINANCIAL REGULATION

The new regulatory architecture embodied in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is a complicated brew—one that changes much but does so without an overarching and coherent structural design. Indeed, it deals only partially with one of the most striking and dangerous aspects of international finance that has developed over the past decade or two, namely the growth of the shadow banking system. These are firms or business units of financial conglomerates that perform key functions of banks but to a significant degree fall outside the regulatory system. They include hedge funds, private equity funds, mutual funds, derivatives, and repo markets that incur market risk, credit risk, liquidity risk, and operational risk. Like water channeling its way to the sea, financial flows seek the least costly and least regulated bypasses, mostly through the shadow banking system. So unless the regulatory architecture encompasses these flows, it is doomed eventually to fail.

Starting with the end of the 2007 to 2009 global financial crisis and taking on board the valuable lessons learned, we can identify four alternative routes to improve the financial architecture in terms of satisfying the criteria we have in mind: encouraging innovation and efficiency, providing transparency, ensuring safety and soundness, and promoting competitiveness in global markets.

Modified Laissez-Faire

The first option essentially involves maintaining the institutional status quo—the Gramm-Leach-Bliley rules permitting financial conglomerates in the United States and universal banking rules in other countries—and allowing banks or bank holding companies to engage in all forms of financial intermediation and principal investing worldwide, subject to certain firewalls and other safeguards. These safeguards would be modified to deal with systemic risk and incorporate the lessons of the financial crisis of 2007 to 2009. This option is heavily favored by the major financial firms in the United States, and major regulators elsewhere have recommitted themselves to the universal banking or financial conglomerate model. Despite much evidence to the contrary, they believe that bigger and broader are better.

Laissez-faire was the initial approach of the Obama administration, which in March 2009 announced a package of proposed regulatory reforms and new measures to deal with systemic risk. These principles are to a large extent reflected in the Dodd-Frank Act. The success of this approach depends critically on the government's ability to install and enforce an effective set of rules through a constellation of new or reinvigorated regulatory agencies covering a wide variety of different types of financial institutions in both the banking and the shadow banking worlds. With much financial intermediation having moved to the shadow banking sector and falling outside of the purview of the existing regulatory agencies, the consequence is a loss of transparency and a huge increase in the informational asymmetries in markets. So getting the regulatory architecture right poses an enormous challenge, given that the regulators themselves have had a dismal record of preventing crises through the enforcement of rules in the existing regulatory structure.

The key elements of a modified laissez-faire approach—one that would improve the safety and soundness of all financial intermediaries—involves (1) creating an appropriate mandate and tools for a systemic risk regulator, (2) pricing implicit public subsidies to systemic financial firms using capital and liquidity requirements, (3) improving the transparency of the financial system, and (4) creating the bankruptcy tools the financial system needs.

The 1930s U.S. financial reforms were truly revolutionary in their time, and in many ways visionary. The modified laissez-faire approach of today is more incremental. It mainly patches holes in a failed system and establishes early warning and corrective action, which would hopefully catch the next big crisis in time to prevent systemwide damage.

Could this modified laissez-faire approach succeed? Much depends on how well the new systemic risk regulator—the Federal Reserve—is able to do its job. Is it really likely that systemic institutions that have shown themselves to be too big and complex to manage and too big, complex, and interconnected to regulate by the past regulatory structure will in the end be rendered fail-safe under the evolutionary new regime?

There is also the issue of regulatory capture. The ease with which the investment banking industry was able to convince the Securities and Exchange Commission (SEC) to allow an increase in its leverage ratios in 2004, or the banking industry was able to capture the Federal Deposit Insurance Corporation (FDIC) politically and get in place limits on FDIC insurance contributions, or the commercial banking industry was able to undermine hard-fought progress on fair value accounting and permit banks to manipulate earnings in 2009 does not augur well for future regulatory capture. Nor does the 2010 report of the Lehman Brothers bankruptcy examiner regarding the firm's ability to collectively bamboozle regulators, auditors, rating agencies, lawyers, and investors by slipping through the cracks in the system—for example, by creatively using repo transactions. It will not be the last time. Much talent in the years ahead will be devoted to avoidance, evasion, obfuscation, and financial innovation with little or no commercial or social purpose.

Critics of the Federal Reserve as the lead regulator of systemic financial firms have argued that its track record in the run-up to the most recent crisis proved to be very poor indeed. Together with the U.S. Treasury, its damage-control efforts in the crisis broke all precedents and increased the amount of moral hazard and competitive concentration in the financial system. It was not necessarily worse than the combined efforts of the Bank of England and the Financial Services Authority in the United Kingdom, or the European Central Bank (which does not have a direct regulatory mandate) and the gaggle of national regulators in continental Europe. Like the United States, it's back to the drawing board for the regulatory architecture in major financial systems around the world.

Excessive pessimism is certainly premature, but the Fed's increased politicization is a virtual certainty going forward, as its mandate extends further from monetary policy into politically sensitive macro-prudential and micro-prudential domains. So it is surely a design weakness of the laissez-faire approach if it permits monetary policy to be distorted by these new mandates.

However, successful pricing of systemic risk using a combination of capital and liquidity requirements, along with the cost of more intense supervision, holds considerable promise. These are aforementioned taxes that are intended to internalize the negative externalities created by firms that produce systemic risk. Ultimately, their success will depend on how effectively they reflect the systemic risk of the financial institutions subject to them, and how these requirements are extended into the shadow banking system. If boards and managements are doing their jobs, they will carefully reexamine the costs and benefits of remaining massive financial conglomerates, for example, and find ways of escaping into less heavily taxed nonsystemic organizational forms.

Glass-Steagall 2.0

The argument for reinstating Glass-Steagall-like bank activity restrictions is that certain profitable but volatile activities of investment banks and other parts of the shadow banking system are incompatible with the special character of commercial banking—namely, operating the payments system, taking deposits and making commercial loans, and serving as the transmission belt for monetary policy. These activities include underwriting and dealing in corporate debt and equities, asset-backed debt and certain other securities, derivatives of such securities as credit default swaps, principal investing, and managing in-house hedge funds. These activities are also deemed to be incompatible with access to Federal Reserve discount facilities, debt guarantees, and other types of government support intended to safeguard the public-utility attributes of commercial banking.

Under this regulatory option, the legacy investment banks that converted to bank holding companies during the crisis in order to gain full access to the government safety net (Goldman Sachs and Morgan Stanley) would revert to broker-dealer status a...

Table of contents

• Cover
• Half Title Page
• Series
• Title Page
• Copyright
• Dedication
• Foreword
• Preface
• Prologue: A Bird’s-Eye View
• Part One: Financial Architecture
• Part Two: Systemic Risk
• Part Three: Shadow Banking
• Part Four: Credit Markets
• Part Five: Corporate Control
• Epilogue
• About the Authors
• About the Blog
• Index