Dodd-Frank and the Future of Financial Regulation
The Harvard Business Law Review is pleased to announce the publication of its inaugural issue. By focusing on specific aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act, each of the following scholars helps to illuminate the merits and missteps of this century’s most sweeping financial reform.Lucian A. Bebchuk
Edolphus “Ed” Towns
Bobby L. Rush
ARTICLESLynn A. Stout
Experts still debate what caused the credit crisis of 2008. This Article argues that dubious honor belongs, first and foremost, to a little-known statute called the Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis was not primarily due to changes in the markets; it was due to changes in the law. In particular, the crisis was the direct and foreseeable (and in fact foreseen by the author and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives. Derivative contracts are probabilistic bets on future events. They can be used to hedge, which reduces risk, but they also provide attractive vehicles for disagreement-based speculation that increases risk. Thus, as an empirical matter, the social welfare consequences of derivatives trading depend on whether the market is dominated by hedging or speculative transactions. The common law recognized the differing welfare consequences of hedging and speculation through a doctrine called “the rule against difference contracts” that treated derivative contracts that did not serve a hedging purpose as unenforceable wagers. Speculators responded by shifting their derivatives trading onto organized exchanges that provided private enforcement through clearinghouses in which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives risk. In the twentieth century, the Commodity Exchange Act (CEA) largely replaced the common law. Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. For many decades, this regulatory system also kept derivatives speculation from posing significant problems for the larger economy.These traditional legal restraints on OTC speculation were systematically dismantled during the 1980s and 1990s, culminating in 2000 with the enactment of the CFMA. That legislation set the stage for the 2008 crises by legalizing, for the first time in U.S. history, speculative OTC trading in derivatives. The result was an exponential increase in the size of the OTC market, culminating in 2008 with the spectacular failures of several systemically important financial institutions (and the near-failures of several others) due to bad derivatives bets. In the wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). Title VII of the Act is devoted to turning back the regulatory clock by restoring legal limits on speculative derivatives trading outside of a clearinghouse. However, Title VII is subject to a number of possible exemptions that may limit its effectiveness, leading to continuing concern over whether we will see more derivatives-fueled institutional collapses in the future.
Charles K. Whitehead
The Volcker Rule prohibits proprietary trading by banking entities—in effect, reintroducing to the financial markets a substantial portion of the Glass-Steagall Act’s static divide between banks and securities firms. This Article argues that the Glass-Steagall model is a fixture of the past—a financial Maginot Line within an evolving financial system. To be effective, new financial regulation must reflect new relationships in the marketplace. For the Volcker Rule, those relationships include a growing reliance by banks on new market participants to conduct traditional banking functions. Proprietary trading has moved to less-regulated businesses, in many cases, to hedge funds. The result is likely to be an increase in overall risk-taking, absent market or regulatory restraint. Ring-fencing hedge funds from other parts of the financial system may be increasingly difficult as markets become more interconnected. For example, new capital markets instruments—such as credit default swaps—enable banks to outsource credit risk to hedge funds and other market participants. Doing so permits banks to extend greater amounts of credit at lower cost. A decline in the hedge fund industry, therefore, may prompt a contraction in available credit by banks that are no longer able to manage risk as effectively as before.In short, even if proprietary trading is no longer located in banks, it may now be conducted by less-regulated entities that affect banks and banking activities. Banks that rely on hedge funds to manage credit risk will continue to be exposed to proprietary trading—perhaps less directly, but now also with less regulatory oversight, than before. The Volcker Rule, consequently, fails to reflect an important shift in the financial markets, arguing, at least initially, for a narrow definition of proprietary trading and a more fluid approach to implementing the Rule.
P. Morgan Ricks
Like bank deposits, money market instruments function in important ways as “money.” Yet our financial regulatory regime does not take this proposition seriously. The (non-government) issuers of money market instruments—almost all of which are financial firms, not commercial or industrial ones—perform an invaluable economic function. Like depository banks, they channel economic agents’ transaction reserves into the capital markets. These firms thereby reduce borrowing costs and expand credit availability. However, this activity—“maturity transformation”—presents a problem. When these issuers default on their money market obligations, they generate adverse monetary consequences. This circumstance amounts to a market failure, creating a prima facie case for government intervention. This Article evaluates policy alternatives in this area. It finds reasons to favor establishing money creation as a sovereign responsibility by means of a public-private partnership system—in effect, recognizing money creation as a public good. (This is just what modern bank regulation has done for decades.) Logically, this approach would entail disallowing access to money market financing by firms not meeting the applicable regulatory criteria—just as firms not licensed as banks are legally prohibited from issuing deposit liabilities. Against this backdrop, the Article reviews the Dodd-Frank Act’s approach to regulating money creation. It finds reasons to doubt that the new law will be conducive to stable conditions in the money market.
Annette L. Nazareth and Margaret E. Tahyar
Existing supervisors, as well as the new institutions that the Dodd-Frank Act created, collect and aggregate an unprecedented amount of commercially sensitive financial information. Although financial institutions and their supervisors are increasingly transparent in the post financial crisis era, some information that financial institutions provide regulators should be protected from disclosure. Untimely public disclosure of sensitive and competitive information— through FOIA requests, third-party subpoenas, or Congress—could undermine the goals of the Dodd-Frank Act by creating upsetting markets and making financial institutions reluctant to disclose data to the government voluntarily. The Article argues that when it passed the Dodd-Frank Act, Congress, out of an understandable desire to promote transparency in the financial system, created an intolerable level of uncertainty as to whether information that regulators gather will be kept confidential. The Article argues that regulators and Congress should act to strike a proper balance between transparency and confidentiality rather than allowing courts to determine the legally required level of disclosure in an unpredictable and ad hoc fashion. Richard W. Painter
In Morrison v. National Australia Bank, the U.S. Supreme Court ruled in June 2010 that securities fraud suits could not be brought under Section 10(b) of the Exchange Act against foreign defendants by foreign plaintiffs who bought their securities outside the United States (so called “f-cubed” securities litigation). The Court held that Section 10(b) reaches only fraud in connection with the “purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” Congress responded to Morrison with Section 929P of the Dodd-Frank Act, which gives federal courts jurisdiction over some similar cases if they are brought by the SEC or the Department of Justice (DOJ). This Article discusses alternative explanations for why Congress used extraterritorial jurisdiction language in Section 929P instead of directly addressing the reach of Section 10(b) on the merits, and whether as a result Section 929P does nothing more than confer jurisdiction on federal courts that the Morrison opinion already recognized courts have over all Section 10(b) cases. This Article also discusses whether Section 929P reinstates for SEC and DOJ suits some of the case law in the courts of appeals that was overturned by Morrison, and if so, how that case law is to be applied. This Article discusses whether Section 929P is retroactive, and how Section 929P likely will be used by the SEC and DOJ in insider trading and other cases. Finally, this Article discusses whether Section 929P was necessary given the SEC’s already expansive enforcement authority under Section 10(b) and whether Congress should have taken the opportunity to address other more pressing post-Morrison issues in Dodd Frank. These issues include the status under Morrison of securities listed both in the United States and outside the United States, and the status of off-exchange traded security-based swap agreements, as well as other private transactions where identifying a transaction location is not as easy as it is for exchange traded securities. John C. Coffee, Jr.
Although dissatisfaction with the performance of the credit rating agencies is universal (particularly with regard to structured finance), reformers divide into two basic camps: (1) those who see the “issuer pays” model of the major credit ratings firms as the fundamental cause of inflated ratings, and (2) those who view the licensing power given to credit ratings agencies by regulatory rules requiring an investment grade rating from an NRSRO rating agency as creating a de facto monopoly that precludes competition. After reviewing the recent empirical literature on how ratings became inflated, this Article agrees with the former school and doubts that serious reform is possible unless the conflicts of interest inherent in the “issuer pays model” can be reduced. Although the licensing power hypothesis can explain the contemporary lack of competition in the ratings industry, increased competition is more likely to aggravate than alleviate the problem of inflated ratings. Still, purging conflicts is no easy matter, both because (1) investors, as well as issuers, have serious conflicts of interest (for example, investors dislike ratings downgrades) and (2) a shift to a “subscriber pays” business model is impeded by the public goods nature of credit ratings. This Article therefore reviews recent policy proposals and considers what steps could most feasibly tame the conflicts of interest problem.
Jonathan M. Edwards
Regulatory forbearance was widely blamed for increasing losses to deposit insurance funds in the 1980s. As part of the legislative response, Congress created a system of Prompt Corrective Action and expanded the grounds for appointing the FDIC receiver of a bank—changes partially intended to limit regulators’ ability to forbear. The recent financial crisis similarly evidenced regulatory forbearance, but Congress did not have the same determination to limit regulatory forbearance. As an afterthought, Congress created a system of early intervention called Early Remediation for systemically important financial companies. Instead of developing a comprehensive system like it did for Prompt Corrective Action, Congress requires the Federal Reserve to create the Early Remediation system. The Federal Reserve is now empowered to create a system that is completely discretionary and relies on the same regulatory judgment that failed in the recent crisis. A system of subjective early intervention is no different from regulators’ safety and soundness authority and will not limit regulatory forbearance or prevent its catastrophic consequences. In a similar vein, Congress created a system of orderly liquidation for systemically important financial companies that uses a closure rule that is prone to regulatory forbearance. Without a congressional limit on regulatory forbearance, we are reliant on market discipline to check regulatory forbearance even though it can cause the same systemic consequences that the Dodd-Frank Act failed to address. We can only hope that, in order to prevent another financial crisis, the regulators who are implementing the Federal Reserve-created Early Remediation system are conscious of the consequences of their inaction. Aron M. Zuckerman
This Note analyzes securitization reform proposals through an examination of the underlying economic justification for securitization. The Note focuses on the increase in private label asset-backed securitization of residential mortgage loans from 2002–2006 and the corresponding subprime bubble. The analysis is motivated by a recognition that securitization and financial innovation were lauded for twenty-five years and that recent reform proposals have not challenged the underlying economic justifications for securitization. Nevertheless, there is widespread recognition that securitization led to an over-supply of mortgage credit available in the United States. This Note utilizes Coase’s theory of the firm to explain the disintermediation of credit markets and the appeal of securitization to banks and lenders. It then analyzes securitization reform proposals with the same Coasean framework and notes that the costs of securitization are not strict principal-agent problems. Rather, the contracting costs of securitization inhibit the ability of parties to identify the residual risk-bearer. Residual risk-bearers are best qualified to monitor the risks of over-supply and weak originating standards in securitization markets. The Note concludes by identifying improved representations and warranties as the reform proposal most likely to account for the contracting costs imposed by securitization. Enhanced representations and warranties and explicit disclosure requirements would impose contracting costs and proper restraint on sponsors and would require them to properly identify the risk factors and risk-bearers in securitization.