Financial reform has passed its final hurdle to becoming law. Last week’s Senate vote on the bill’s conference report and the pending signature of the president now usher in far-reaching, though little understood, changes to the nation’s financial system. Details of the law aside, its passage heralds a reversal of long-term deregulation and a medium-term outlook characterized by more aggressive enforcement. The civil fraud case against Goldman Sachs, while controversial in its settlement, is just one example of how federal agencies have been emboldened by the changing winds in Washington.
With the overtly political phase of the sector’s restructuring debate now behind us, a host of relatively more opaque regulatory processes will now begin to clarify how Dodd-Frank will function in practice. This clarification will take years; making sense of the new law will be a daunting task, both for regulators and the firms they oversee.
With this in mind, Harvey Pitt, former chairman of the Securities and Exchange Commission, described the bill as “the Lawyers’ and Consultants’ Full Employment Act of 2010.” Good news: I may yet monetize the time spent in reading the conference report.
It is a sign of the times that kidney stones may be passed with more poise than high-minded legislation. In the final weeks of the reconciliation process, many of the bill’s most divisive provisions fell victim to the procedural need for 60 affirmative votes in the Senate. In the end, a number of senators on the winning side concluded that while the bill was not perfect, it was the best that could be passed.
Of course, opponents of the bill still conclude that it will raise the cost of credit to a degree that will impinge on American competitiveness. But this view is not universally held among Republicans. Hank Paulson, the former Treasury secretary, opined in The Wall Street Journal last week that “[s]ome argue higher capital and liquidity cushion requirements will slow economic growth. That’s short-sighted. … Higher capital and liquidity requirements will give us more stable long-term growth.”
Ongoing disagreements over how to preclude another crisis will persist, as do disagreements over what triggered the crisis. There is the potential for reform and improvement in every aspect of the financial system. The characterization of the crisis, however, still suggests an unwillingness to acknowledge systemic failures, indicating shortsightedness on the part of policy makers and consumers in addition to the nation’s financial engineers. In remarks following the Senate vote, the president did not equivocate in his view that the recession “was the result of recklessness and irresponsibility in certain corners of Wall Street that infected the entire economy.”
The president went on to state that “because of this reform, the American people will never again be asked to foot the bill for Wall Street’s mistakes.” I certainly appreciate the importance of reassuring the American public that Dodd-Frank will usher in a period of greater stability. But to suggest that we have conclusively identified and corrected the market imperfections that lead to systemic financial crises is unwarranted.
Basel Committee Has Plans of Its Own
The president clearly recognizes that “the financial industry is central to our nation’s ability to grow, to prosper, to compete and to innovate.” And so he may be concerned about how the potential changes that will arise from Dodd-Frank might render the United States a less competitive home for capital. Ideally, other countries will be acting to strengthen their regulatory regimes in kind. Just a few weeks ago, the absence of lock-step agreement on a global bank tax doomed that effort to failure.
A problem for the domestic financial system is that cross-country imbalances in the strength of regulatory oversight will, all things being equal, drive capital to less costly havens. Although with less fanfare, it is with this in mind that central bankers and regulators have been working on an update to global risk rules that, if ever brought to their logical conclusion, will normalize rules for additional risk capital.
In the shadows of the Senate vote, the Bank of International Settlements’ Basel Committee on Banking Supervision released its proposal for countercyclical capital buffers last week. While the work of the Basel Committee has been prompted by the very same financial crisis, its definition of the problem is more cogent and lacks the bluster of Dodd-Frank’s preamble. The former pinpoints a basic challenge in managing losses that exhibit a lagged correlation with growth in credit:
“The financial crisis has provided a vivid reminder that losses incurred in the banking sector can be extremely large when a downturn is preceded by a period of excess credit growth. These losses can destabilise the banking sector and spark a vicious cycle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector.”
In principle, the solution to the problem should be as straightforward as its identification: “… These interactions highlight the particular importance of the banking sector building up its capital defences in periods where the risks of system-wide stress are growing markedly. As capital is more expensive than other forms of funding, the building up of these defences may have the additional benefit of helping to moderate excessive credit growth when economic and financial conditions are buoyant.”
At least in principle, the work of the Basel Committee is good for American competitiveness since, in the best case, it will limit the opportunity to arbitrage across risk frameworks. Unfortunately, our experience with Basel II-the erstwhile New Basel Capital Accord-suggests that it may take a decade or more to hammer out workable guidelines for what is being dubbed Basel III. In the interim period, the work of the committee will come under some of the same lobbying pressures that we see in the United States.
The reader who is so inclined will have until Sept. 10 to offer comments to the Basel Committee on the merits of its new consultative document. There is a level of detail in the proposal that one does not find in a legislative context. Do not dismay of the equations contained in its pages. Rather, rest assured that I will be reading and writing about this global reform in yet another attempt to capitalize on Mr. Pitt’s Full Employment Act.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.