"The Finance Bill - Dodd Promises Reform, Except for Congress"

Sydney M. Williams

Thought of the Day

“The Finance Bill – Dodd Promises Reform, Except for Congress”

March 17, 2010

Increased regulation of the financial world took another step closer, as Senator Dodd released his revised draft version of a bill Monday afternoon.

The bill, common in this day of excessive verbiage, is 1136 pages long, so who knows what lurks within its pages? However, below are a few key elements and some of my thoughts:

The centerpiece of the legislation is the creation of a Consumer Protection Authority, to be embedded in the Federal Reserve. The purpose is to protect naïve and gullible consumers from predators such as abusive and deceptive lenders, brokers and others intent on separating people from their money. While there is little question that greater transparency is warranted and laws clearly stated and enforced, the risk is the increasing dependency of the consumer on the benevolence of the State. Like all entitlements, protections of this sort can be addictive and reduce the responsibility individuals should have for poor decisions they make.

The bill creates a Financial Stability Oversight Council, which would consist of nine members drawn from existing regulatory bodies, chaired by the Secretary of the Treasury and housed within the Federal Reserve. Its purpose would be to act as an early warning system, as it monitors financial firms for the possibility of systemic risk. That seems to me a good idea.

The bill also creates the “Volcker” Rule, which would prohibit banks from engaging in proprietary trading and investing in and sponsoring hedge funds and private equity funds. The practical application of this provision, as it applies to prop desks (for distinguishing between trades done to accommodate customers and those done for the sole benefit of the bank will be difficult to determine), may make this difficult to pass or enforce. There would be consequences. Since Goldman Sachs and Morgan Stanley would be forced to retain their bank charters, it is possible – and perhaps likely – that prop trading operations, along with hedge fund and private equity operations could be spun off into private partnerships. Personally, I like the Volcker Rule and know, if I were a prop trader, I would rather work for a private partnership than a public firm operating in the gun sights of the federal government.

A Financial Rescue Fund would be established with $50 billion funded by large financial institutions. The purpose would be to avoid the necessity of any future crises needing to tap the resources of the tax payer. The large banks will condemn this idea, but to me it makes sense. When one’s own money is at risk, greater discretion is likely to be employed. That principle would apply in this instance.

The question regarding derivatives and whether they should be subject to a central clearing house and trade on electronic exchanges was not fully resolved. In part that is because many derivative products are custom tailored to fit a specific situation, but greater transparency is called for. I have long felt that general derivative contracts should trade on exchanges and that products such as credit default swaps should be considered and governed as the insurance products they are. But there must be allowance for the continued creation of and allowance for tailor-made derivative contracts.

There are a number of other rules. A rule providing shareholders more of a say in corporate compensation through a non-binding vote, while sounding attractive, my guess would prove to be more cosmetic than effectual. Significant shareholders should benefit from this rule, though, so I like it. I understand that leverage would be reduced – a good thing – and that rating agencies would come under greater scrutiny, also a good thing.

However, there is nothing in the bill indicating the complicit role played by Congress, or holding its members to stricter standards – think Senator Dodd and how, as a “friend of Angelo Mozilo” he was provided favorable treatment on his Irish farmhouse.

What I like best about the bill is its emphasis on transparency and I like the fact that the Fed appears to be the big winner. The Federal Reserve is, despite its members being selected by the President, supposedly independent of the executive branch. (As an aside, I do not like the provision that the chairman of the New York Fed should be appointed by the President, rather than the current method of being elected by the board of the Fed.)

What I like least is that it does not appear to address the question of influence that the banking industry has on regulators (including members of Congress), and I dislike the sense that consumers, who, like other parties were also guilty of greed and willful ignorance, are given not only a pass for irresponsible behavior, but look to be further protected. I am a firm believer that people should reap the benefits and suffer the consequences of their actions. I recognize that there are legitimate victims and they should be protected and made whole, but society must be careful of this slippery slope.

To my mind, changes are needed and this bill addresses many of them; transparency is critical and this bill appears to address that; on the other hand rules should not stifle creativity. It is also no guarantee against another crisis. Yesterday, Senator Dodd was quoted in the New York Times: “This legislation will stop the next crisis from coming. No legislation can, of course.” He is right. A $40,000 bank examiner is no match against a $5,000,000 Wall Street prop trader.

Many aspects of the bill will serve to raise costs for banks and that might well result in banks charging higher interest rates and doing more due diligence, thereby hampering loan availability and, thus, economic growth. These rules could well decelerate growth – a consequence that needs understanding.

Keep in mind, economic growth over the past decade, has been accompanied by a widening of debt. In fact GDP growth, in the past decade, looks to have been a function of debt expansion. Between 2000 and 2007, U.S. GDP grew from $9.8 trillion to $14.5 trillion, an expansion of 58%. Consumer debt, during the same period, increased 100% from about $7 trillion to $13.8 trillion, and U.S. Government debt widened 70% to $9.0 trillion. A shrinking of debt may well have the opposite effect.

Nevertheless, the near meltdown of late 2008 was an experience none of us is anxious to revisit and this bill is a start toward redemption.