How Much Was Bank Regulation Weakened in the New Budget Bill? And What Can Be Done Now?

A.  Introduction

In a rare, late-night and weekend, session, the US Senate on Saturday night passed a $1.1 trillion government funding bill to keep the government running through to the end of fiscal year 2015 (i.e. until September 30, 2015).  The House had passed the bill on Thursday, and it has now gone to Obama for his expected signature.  Had it not been passed, the government would once have been forced to shut down due to lack of budget authority.  It was a “must-pass” bill, and as such, was a convenient vehicle for a number of provisions which stood little chance to pass on their own, but which could only be blocked by opponents now at the cost of forcing a government shutdown.  The specific provisions included were worked out in a series of deals and compromises between the leadership of the Republican-controlled House and the now Democrat-controlled (but soon to be Republican-controlled) Senate.

One such provision was an amendment to the Dodd-Frank Wall Street reform bill, originally passed in July 2010, which enacted a series of measures to strengthen the regulatory framework for our financial sector.  The failure of this framework had led to the 2008 economic and financial collapse in the last year of the Bush administration.  The amendment in the new budget bill addressed just one, and some would say relatively minor, provision in Dodd-Frank.  But its inclusion drew heavy criticism from liberal Democrats, led by Senator Elizabeth Warren of Massachusetts.  Senator Warren argued that the amendments to Section 716 of Dodd-Frank would “would let derivatives traders on Wall Street gamble with taxpayer money and get bailed out by the government when their risky bets threaten to blow up our financial system.”  The amendments were reportedly first drafted by lobbyists for Citibank, and would benefit primarily a very small group of large Wall Street banks.

The amendments do reflect a backwards step from the tighter controls on risk that Dodd-Frank had provided for.  In my view, it would have been better to have kept the original provisions on the issue in Dodd-Frank.  But with a positive response now by the regulators to the reality of this new provision, the impact could be negated.  This blog post will discuss what was passed, what could be done now by bank regulators to address the change, and the politics of it all.

B.  The Amendment to Dodd-Frank, and the Economics of Derivatives

The amendment to Dodd-Frank addresses one specific provision in a very large and comprehensive bill.  An important link in the 2008 financial collapse was the risk major banks had carried on their books from certain financial derivative instruments.  “Derivatives” are financial instruments that derive their price or value from the price or value of some other product.  For example, oil derivatives derive their value from the price of oil (perhaps the price of oil at some future date), foreign exchange derivatives are linked to foreign exchange rates, credit default swaps are linked to whether there is a default on some bond or mortgage or other financial instrument, and so on.

Derivatives can be quite complicated and their pricing can be volatile.  And they can lead to greater, or to reduced, financial risk to those who hold them, depending on their particular situation.  For example, airlines must buy fuel to fly their planes, and hence they will face oil price risk.  They can hedge this risk (i.e. face reduced risk) by buying an oil derivative that locks in some fixed price for oil for some point in the future.  An oil producer similarly faces an oil price risk, but a bad risk for it is the opposite of what the airline faces:  The oil producer gains when the price of oil goes up and loses when it goes down.  Hence both the airline and the oil producer can reduce the adverse risk each faces by entering into a contract that locks in some future price of oil, and derivative instruments are one way to do this.  Banks will often stand in the middle of such trades, as the buyer and the seller of such derivative instruments to the airlines and the oil producers (in this example), and of course to many others.

Derivatives played an important role in the 2008 collapse.  As the housing bubble burst and home prices came down, it became clear that the assumptions used for the pricing of credit default swaps on home mortgages (derivatives which would pay to the holder some amount if the underlying mortgages went into default) had been badly wrong.  Credit default swaps had been priced on the assumption that some mortgages here and there around the US might go into default, but in a basically random and uncorrelated manner.  That had been the case historically in the US, for at least most of the time in the last few decades (it had not always been true).  But this ignored that a bubble could develop and then pop, with many mortgages then going into default together.  And that is what happened.

Dodd-Frank in no way prohibits such derivative instruments.  They can serve a useful and indeed important purpose.  Nor did Dodd-Frank say that bank holding companies could no longer operate in such markets.  But what Section 716 of Dodd-Frank did say was that banks that took FDIC-insured deposits and which had access to certain credit windows at the Federal Reserve Board, would not be allowed, in those specific corporate entities, also to trade in a specifically defined set of derivatives.  That list included, most notably, credit default swaps that were not traded through an open market exchange, as well as equity derivatives (such as on IBM and other publicly traded companies) and commodity derivatives (such as for oil, or copper, or wheat).  The bank holding companies could still set up separate corporate entities to trade in such derivatives.  Thus while Citigroup, for example, could set up a corporate entity owned by it to trade in such derivatives, Citibank (also owned by Citigroup), with its FDIC-insured deposits and with its access to the Fed, would not be allowed to trade in such derivatives.  That will now change.

It is also worth highlighting that under Dodd-Frank, banks with FDIC-insured deposits could still directly trade in such derivatives as interest rate swaps, foreign exchange derivatives, and credit default swaps that were cleared through an organized public exchange.  That had always been so, and will remain so.  The banks could also always hedge their own financial positions.  But they will now be allowed to trade directly (and not simply via an associated company under the same holding company) also in the narrow list of derivative instruments described above.

It is arguable that this is not a big change.  All it does is allow bank holding companies to keep their trading in such derivative instruments in the banks (with FDIC-insured deposits) that they own, rather than in separately capitalized entities that they also own.  The then Chairman of the Federal Reserve Ben Bernanke noted in testimony in front of a House panel in 2013 that “It’s not evident why that makes the company as a whole safer.”

So why do banks (or at least certain banks) want this?  Banks with FDIC-insured deposits and who also have access to certain credit windows at the Fed, are seen in the market as enjoying a degree of support from the government, that other financial entities do not enjoy.  The very largest of these banks may be viewed as “too-big-to-fail”, since the collapse of one or more of them in a financial crisis would in turn lead to a financial cataclysm for the country.  Thus depositors and other lenders are willing to place their money with such institutions at a lower rate of interest than they would demand in other financial institutions.

Thus Senator Warren and others charge that the amendments to Dodd-Frank “would let derivatives traders on Wall Street gamble with taxpayer money and get bailed out by the government when their risky bets threaten to blow up our financial system”, as quoted above.  To be more precise (and less eloquent), any bank with FDIC-insured deposits will make investments with those deposits, those investments will have varying degrees of risk, and if there is a threat that they will fail, the government may decide that it is better for the country to extend a financial lifeline to such banks (as they did in 2008) rather than let them fail.  The amendments to Dodd-Frank will allow these banks to invest in a broader set of derivative contracts directly (rather than only at the holding company level) than they could have before.  Thus they could end up investing directly in a riskier set of assets than they could have before without this amendment, and all else being equal, there could then be a higher risk that they will fail.

Finally, it should be noted that the amendments to Dodd-Frank will benefit largely only four very large banks.  The most recent quarterly report from the Office of the Comptroller of the Currency indicates that just four big banks (Citibank, JP Morgan Chase, Goldman Sachs, and Bank of America) account for 93% of derivative contract exposure among banks (as of June 30, 2014).  While this figure includes all types of derivatives, and not just those on the list that is at issue here, it is clear that trading in such instruments is highly concentrated.

C.  What Can Be Done Now? 

Over the objections of Senator Warren and others, the amendments to Section 716 of Dodd-Frank have been passed as part of the budget bill.  Banks, and in practice a limited number of very large banks, will now be able to take on a riskier set of assets on their balance sheets.  But Dodd-Frank, and indeed previous bank regulation, has established a bank regulatory and supervision regime that requires that banks hold capital sufficient, under reasonable estimates of the risks they face, to keep them out of insolvency and an inability then to repay their depositors.  The bank regulatory and supervision framework was clearly inadequate before, as the 2008 collapse showed.  Dodd-Frank has strengthened it considerably.  The specific rules are now being worked out, and like all such rules will evolve over time as experience dictates.

The amendments to Section 716 of Dodd-Frank will now change the set of risks the banks will possibly face.  I would suggest that now would be a good time for current Fed Chair Janet Yellen, or one of the other senior bank regulators heading up the process or even President Obama himself, to make a statement that they will of course follow the dictate of the law (as spelled out in Dodd-Frank, as it still stands) to take into account these possible new risks as they work out the capital adequacy ratios for the banks that will be required.

Specifically, the statement should make clear that the capital ratios required of banks that trade in these newly allowed instruments will now have to be set at some higher level than would previously have been required, due to the higher risks of such assets now in their portfolio.  It could and should be made clear that the law requires this:  The regulators are required to determine what the capital ratios must be on the basis of the risks being held by the banks in their portfolios.  How much higher the capital ratios will need to be will depend on the riskiness of these new assets compared to what the banks previously invested in, and how significant such new assets will be in their portfolios.  It is quite possible that faced with such higher capital requirements, the banks that had pushed for this new latitude will decide that it would be wiser not to enter into those new markets after all.  They may well come to regret that they pushed so strongly for these amendments to Dodd-Frank.

This is perhaps not the best solution.  The prohibition on direct trading in the proscribed list of certain financial derivative instruments is cleaner and clearer.  Most importantly, while current bank regulators may use their authority to ensure banks hold sufficient capital to reflect the greater risk in their portfolio, there is the danger that regulators appointed by some future president may not exercise that authority as wisely or as carefully.  This was indeed the fundamental underlying problem leading up to the 2008 collapse.  The Bush administration was famously anti-regulation, and Bush appointed officials who were often opposed to the regulations they were in office to enforce.  In at least some cases, the officials appointed who were not even competent to carry out their enforcement obligations.  For example, Bush famously appointed former Congressman Christopher Cox as head of the SEC.  The SEC at the time had the obligation to regulate investment banks such as Lehman Brothers, Goldman Sachs, and Morgan Stanley.  As Lehman Brothers collapsed, with worries that Goldman Sachs, Morgan Stanley, and others would soon be next, Christopher Cox was at a loss on what to do, and was largely by-passed.  Dodd-Frank changed regulatory responsibility (the Fed and other financial regulators are now clearly responsible, where Goldman Sachs and Morgan Stanley had already been “encouraged” to become formal banks and as such subject to Fed oversight), but there is the risk that some future president will choose, like Bush, to put in place figures who either do not believe in, or are not capable of, serious financial supervision and oversight.

In addition, financial crises are always a surprise.  They occur for some unexpected reason.  If they were expected, actions could be taken to address the causes, and they would not happen and hence not be observed.  But surprises happen.  Hence Dodd-Frank, and indeed all financial regulation, includes an overlapping and mutually reinforcing set of measures to try to ensure crises will not occur and that banks will not become insolvent should they occur.  One does not know beforehand which of the regulatory measures might be the critical one for some future and unforeseen set of circumstances leading to a crisis.  it is therefore wise to include what others might call redundancies.  The amendment to Dodd-Frank will remove one of the possibly redundant measures to ensure bank safety.  The remaining measures (e.g. the capital adequacy requirements) may well suffice to address the safety issue, but in cases like this, redundancy is better.

D.  The Politics of It All

While the economics may suggest that the change resulting from the amendment to Dodd-Frank need not be catastrophic if regulators respond wisely, and hence that the amendment is not such a big deal, the politics might be different.

The biggest concern is that many see this as possibly the opening round of a series of amendments to Dodd-Frank and other laws identified with the Obama administration, that a Republican Congress and now Senate will push through on “must-pass” legislation such as budget bills.  Particularly if this had slipped through quietly, with little public attention until after the bill had been passed, the bankers and their Republican representatives could have seen this as a model of how to pass changes to legislation that would not otherwise have gone through.  While the model is certainly not a new one, its affirmation in this instance would have strengthened their case.

The loud objections by Senator Warren and others has served to bring daylight to the changes in financial regulation being proposed.  This will hopefully make it more difficult to push through further, possibly much more damaging, changes to Dodd-Frank at the behest of the banks.

Ensuring attention was paid to the issue also served to make clear who in the House and the Senate are in fact in favor of bank bailouts.  Weakening Dodd-Frank will increase the likelihood (even if only marginally so) that bank bailouts will be necessary in some future crisis to protect FDIC insured deposits and to protect the economy from a full financial collapse.  Republicans, including in particular Tea Party supported Republicans, have asserted they are against bank bailouts.  But their actions here, with the Dodd-Frank amendments inserted into the budget bill at the insistence of the House Republican leadership, belies that.

The actual economic substance of the Dodd-Frank amendments might therefore be limited, especially if there is now the regulatory response that should be required in the environment of certain banks holding more risky assets.  But the politics may be quite different, and could explain why there was such a vociferous response by Senator Warren and others to this ultimately successful effort to weaken a provision in Dodd-Frank.