The Future of Banking: Dodd-Frank at One Year

Well, we have suffered through one year of the new financial reform act passed in 2010.

“Some critics of the law contend that it skimped on the details, leaving regulatory agencies with too heavy a burden” having to write up the specific new rules and regulations.)  

Of the 400 new rules due from the reglators, only 12 percent have been finalized while 33 percent have missed the deadline set for their finalization.  There are still 55 percent of these rules that have a future deadline.

Barney Frank, co-author of the act, said Congress had no other choice.  “We didn’t punt anything.  It’s precisely because we knew we couldn’t get everything exactly right that we did leave room for the regulators.” (http://dealbook.nytimes.com/2011/07/20/barney-frank-financial-overhauls-defender-in-chief/?ref=todayspaper)

Part of this is because Frank…and others…didn’t really know what they were doing.  The article continues “Even he (Frank) concedes that arcane financial matters were never his strong point.” Frank jokes: “I know more now about repos and derivatives than I ever wanted to know.”

The result: we have a Congressional law, the Dodd-Frank Act, aimed at preventing 2008-2009 from happening again, written by people who knew little about banking and finance but had to do something to save the world from the people who ran Wall Street. 

The major concern of Congress was about institutions that were too big to fail.  These “large” banks were to create “living wills” that provided a blueprint of the organization’s operation that would allow regulators to dismantle the bank in an orderly fashion.  (These, of course, have not been written yet.)  And, there were other things about proprietary trading and derivatives and disclosure and so forth.

My conclusion from one year of Dodd-Frank is that the financial industry will survive…in some form…and will do very well over time although not in the way Congress will like.

I must admit, my awareness of the banking and finance industry began in the 1960s.  This was really the first decade that the laws and regulations coming out of the period of the Great Depression were really tested.  The 1940s was a period the United States was focused on war; and the 1950s were devoted toward the country getting back to some kind of normality following an era of world-wide depression and world war.

In the 1960s the fifty-year period of credit inflation got its start and this changed everything.

Since this period has spanned my professional career the evolution that took place is very real to me.  The period started out very calm and contained.  Banks were very limited in what they could do and they were especially constrained geographically.  There were unit banking states where a bank could only have one office; there were limited branching states where a bank could have multiple offices although the number were limited; and there were states that allowed state wide branching.  However, banks could not cross state lines and branch in other states!

There was a definite line between different types of financial institutions.  There were, of course, the commercial banks…and the savings and loan associations…and the mutual savings banks…and the investment banks…and so on and so forth.

The products and services offered by each type of institution were severly limited and closely regulated.  Interest rate ceilings were present to protect depository institutions engaging in “destructive” competition that would weaken the banking system. 

In my mind, two major things occurred as a result of the initiation of credit inflation in the early 1960s.  First, United States corporations grew bigger and bigger.  Second, international flows of capital were freed up from earlier constraints in order to support the growth of world trade. 

The consequence of this was that financial institutions, especially commercial banks, had to break out of their constraints so that they could serve there larger customers, both within the United States and in the world. 

Financial innovation began to roll.  The four biggest financial innovations that took place in the 1960s, I believe, were the formation of bank holding companies, the creation of the negotiable CD, the allowance of bank holding companies to issue banker’s acceptances, and the invention of the Eurodollar deposit.  These innovations basically over came state laws and allowed American commercial banks to become world bankers. 

By the start of the 1970s, state banking restrictions were effectively dead and the freed-up international flow of capital doomed the gold standard which was officially buried by President Richard Nixon on August 15, 1971 when the floated the United States dollar. 

As the credit inflation continued through the last half of the century financial engineering and financial innovation dominated just about everything else other than the growth of information technology.  Perhaps the final nail in the coffin of the 1930s financial regulation was delivered in 1999 as the United States Congress repealed the Glass-Steagall Act of 1933.  This was the act that separated commercial banking from investment banking into separate organizations.

My point in reviewing this history is to make the claim, again, that “economics works.”  If there is an economic reason for an individual or institution to “get around” laws and regulations, then that individual or institution will “get around” those laws and regulations.  Some laws and regulations will fall earlier than others but these latter laws and regulations will be circumvented over time as there develops more and more reason to do so.

In other posts I have argued that the banks that were too big to fail before are now bigger and more prominent than before the recent crash.  Also, financial institutions have already moved way beyond the “intent” of the Dodd-Frank Act in the areas that have the most economic promise, have “cooled it” in other areas, and in some areas where it has not really been worthwhile for them to fight they have relinquished those minor facilities. 

Especially in this “Information Age” finance and financial arrangements are going to be harder than ever to regulate and police.  Finance is nothing more than information, nothing more than 0s and 1s (see many of my posts in the past) and information can be “sliced and diced” almost any way one wants to slice and dice it and can flow, almost instantaneously, throughout the world.

The only thing of benefit that has come out of the new financial reform act has been some increases in transparency but this has not come anywhere close to the level I would like to see happen. 

These are some of the reasons for my conclusion of one year of Dodd-Frank that the financial system will survive.  However, the system that is evolving will be a lot different than what we see now and a lot different from what the Congress and the regulators would like to see.  Also, I am still predicting that the number of financial institutions in the system will drop below 4,000 (from a little less than 8,000 now) over the next five years. 

Let’s just hope that Congress and the regulators don’t chase most of the finance offshore.    

Fannie Mae, Freddie Mac and the Future

Earlier this year a friend of mine and his wife got a mortgage on their new home. (As of today, they have only been married three hundred and fifty-three days.) Let me just say that the price of their home is well into the six figures. They borrowed twenty percent of the purchase price. Both of them have established, on their own, a credit rating of at least A and they pay off all of their revolving credit every month.

About two months after signing the mortgage my friend came to see me. He could not believe that his mortgage was now owned by Fannie Mae! Never in his lifetime did he expect to have a mortgage of his owned by this organization!

But, this is a part of modern America. It is a part of the whole effort by government for people to own “things.” Owning “things” in America is good! Monarchs and other royalty owned “things”. The evolution of the wealthy capitalist included owning “things.” It became the right of every American to own “things.”

And, this desire to own “things” played right into the hands of greedy politicians because politicians could promise to deliver “things” to the people that elected them and thereby get elected and re-elected. In the twentieth century, the “thing” of most importance was a home of one’s own. After all, the number one job of a politician is to stay in office! (http://seekingalpha.com/article/219804-wall-street-greed-vs-washington-greed)

Talk about financial innovations. The United States government is one of the most prolific financial innovators the world has ever seen. Just look at the last one hundred years: savings and loan associations, the Federal Home Loan Bank Board, the Federal Savings and Loan Insurance Corporation, the Office of Thrift Supervision, the Federal National Mortgage Association, the Federal Housing Authority, the Department of Housing and Urban Development, the Federal National Mortgage Association, the Government National Mortgage Association, the Mortgage-backed security, and so on and so on.

The surprise is that Fannie Mae and Freddie Mac don’t own more mortgages than they do!

Government programs based on achieving outcomes generally fail. There are two reasons why they fail. First, the goals and objectives of programs focused upon outcomes are generally not based on economics but are based upon achieving desired social consequences. Second, if a program seems to contribute in any way to politicians getting re-elected, more and more resources will be put into that program going forward.

“Popular” programs based on outcomes seem to grow exponentially as each party seeks to “out-do” the other in promising even more to more people. The underlying economics of the situation do not seem to play any role in the cumulative expansion of such programs.

How can people improve things when they tend to hold onto the “old” assumptions? This is a very difficult problem. We see the tip of the iceberg in the column by Andrew Ross Sorkin, “2 Zombies to Tolerate for a While,” in the New York Times (http://www.nytimes.com/2010/08/17/business/17sorkin.html?_r=1&ref=business) where Sorkin discusses what Congress should do about Fannie Mae and Freddie Mac with Congressman Barney Frank. To Frank, Congress has acted as it should have, well maybe a little later than it should have, but things are under control now. The point being: “money is not being lost by anything they (the agencies) are doing now.” The Congressional Budget Office says that taxpayers could absorb almost $400 billion in losses over the next decade, but, to Barney Frank, this is a result of what has happened in the past. Therefore, the agencies just need to be put on a working basis to go forward.

Yet, this doesn’t get at the fundamental issue which has to do with Americans owning “things”. As long as the focus of the government doesn’t change, the problems will not be resolved.

Again, Congress seems to be fighting the last war. As with the financial reform bill that has just been passed by the Congress (http://seekingalpha.com/article/213263-financial-reform-ho-hum), efforts to reform the housing agencies just aim at preventing what has happened over the past ten years or so. It does not deal with the fundamental issue of what it is trying to achieve (the goal itself) and whether or not this goal can be achieved.

However, the world has already changed and will continue to change.

For one, the world is changing at a much faster pace than it did a decade or two ago. Technology, for one, is changing at an ever increasing pace. People do not stay in the same place as long as they did in the past. Families are more divided geographically than ever before and one out of every two marriages ends up in divorce. Small- and mid-sized businesses rise and fall, grow and are sold, and expand and contract. Many people argue that owning “things”, especially “things” that cost a lot of money, will not be as attractive in the future as they have been in the past. The spending (leasing and renting) habits of Americans are changing.

In finance, the environment has also changed over the past fifty years. The whole idea behind the mortgage-backed security was to generate more cash going into the housing market by creating an instrument that pension funds and insurance companies would hold to match their liabilities thereby getting mortgages off the balance sheets of depository institutions, the originators of the mortgages. The idea was that these latter organizations could then create more mortgages.

This effort was based upon a “static” model of how financial intermediaries worked. With the inflation of the 1960s and 1970s, the model for financial intermediaries changed and became more “dynamic” in nature. By the second half of the 1980s, mortgage instruments became the largest component of the capital markets and the volume of trading in this sector was huge. Trading in mortgages became the most spectacular and volatile part of the capital markets.

With the growth in the number of other mortgage instruments, securitization, and derivative instruments, the mortgage finance industry became one of the hottest things around. This was not something the creators of mortgage-backed securities in the late 1960s expected. And, as with other areas experiencing financial innovation, new and more wonderful instruments can still be expected.

Congress continues to work with a “static” model of financial institutions and a perception that people will continue to focus on “things”. Both are wrong!

As a consequence, whatever Congress creates out of Fannie Mae and Freddie Mac, financial incentives will be set up so that people can “game” the system and take advantage of the efforts Congress makes to attain its social goals.

Maybe one day the government will own all the mortgages on all the homes in America. Some people may think that this would be a good thing. On the contrary, it would be just another story of the less well-to-do paying for the pleasures of the more well-to-do.

Who do you think is going to bear the burden of the almost $400 billion cost of Fannie Mae and Freddie Mac the Congressional Budget Office projects? Certainly not the wealthy. Why is it so hard for the people in government to see that the wealthy have enormous resources available to them to protect their incomes and wealth. The less-well-off do not have those resources. Consequently, over time, the burden falls upon the latter even on the programs designed to help them.

The Upcoming Banking/Financial Regulation

New financial regulation is on the horizon. As with the health care program, the Obama administration is providing very little unified leadership as to where it really stands and, as a consequence, there is a multitude of plans being tossed out into the air. There is, more or less, a Treasury plan, an FDIC plan, a Barney Frank plan, a Federal Reserve plan and so on and so on.

Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.

From what I have seen I am not very comfortable. As is usual, the politicians sense a “popular” issue with the public. “Something must be done!” is the cry. But, as is typical, the politicians, in my mind, are fighting the last war.

There are three topics that seem to be missing in every discussion about new regulation or re-regulation.

First, how does one control and/or penalize “bad” monetary and fiscal policies that can lead to financial stress and a breakdown of the system? How do we overcome the economics of mis-directed presidential administrations? How can we keep the Federal Reserve and the Treasury Department under control when their policies are coming from the likes of Alan Greenspan, Ben Bernanke, Paul O’Neill, Jack Snow, and Henry Paulson?

The actions of the federal government impact the whole country. The actions of the United States government impact the whole world. What the government does changes the incentives in the whole system, how people conduct their lives and their businesses.

Yes, individuals did wrong and took advantage of other people. Yes, corporations and other organizations did not perform prudently. But, they did not create the environment in which such behavior became profitable.

I don’t care what regulations are put into place, when your government, year-after-year, creates trillions of dollars in debt and the monetary authorities keep interest rates at ridiculously low levels for extended periods of time you are going to change incentives and create opportunities for people to take advantage of the system and other people and organizations.

Second, if finance is fundamentally just information, how does one really control and regulate financial innovation? One of the things we have learned about information and the spread of information is that it cannot be controlled. It is easy to take “information” off-shore. It is easy to transform “information” into different forms and into different organizational structures. The world of the future will consist of more and more financial innovation and not less. And, this innovation will happen somewhere because it is easily transported to anywhere in the world, if necessary. And, in real time!

Third, the best regulation is that which emphasizes “processes” and not “outcomes.” We need regulatory systems that produce openness and not secrecy. We need economies that do not contribute to a covering-up of transactions whether it be for tax or flows of funds purposes (see the Financial Times, “Leading Economies Blamed for Fiscal Secrecy”: http://www.ft.com/cms/s/0/ea9f6964-c57a-11de-9b3b-00144feab49a.html) or whether it be for deals (see the Financial Times, “Trading in European ‘Dark Pools’ leaps Fivefold since the start of the year”: http://www.ft.com/cms/s/0/a43d96f0-c74e-11de-bb6f-00144feab49a.html).

Controls, prohibitive restrictions, price limits, artificial scarcities all lead to “black markets” whether the products and services are goods or whether they are just information.

Strict regulations aimed at “outcomes” just tend to drive people and organizations into areas that are less controlled and that are more opaque, less transparent. Is this what we want?

Our rules and regulations should help provide efficiencies and reduce the costs of information to the public. These rules and regulations will not stop individuals and organizations from taking too much risk or from possible financial dislocation. However, the more everyone knows what is going on, in my mind, the better off everyone will be. Also, the economic and financial system will operate better and the swings will be more incremental movements rather than discrete jumps.

Of course, my concerns are not popular with politicians for two reasons. The first is that the voters want to see something tangible done by the government. Developing rules and regulations that are meant to achieve “outcomes” are something that can be bragged about, even if they don’t work very well. Trying to explain that finance is another form of information and that financial innovation cannot really be controlled is difficult to do when the public sees all the perks and benefits that are associated with financial wealth.

The second reason is that politicians have difficulty claiming that government might be the root cause of the problem, especially when they have been a part of that government. Those that govern very seldom support the argument that government might be a cause of difficult times because government is so often looked upon as the solution to the problems we encounter, especially when the problems are of national or international scope.

We are going to get some new regulatory structure and that regulatory structure will, over time, prove to be insufficient to achieve what people hope that it will achieve. The last major change in regulatory structure was enacted in the 1930s. It took until the latter part of the 1990s to eliminate almost all of that structure. Millions and millions of dollars were spent over that 60-70 years to get-around that regulatory structure. Also, much brain-power was devoted to escaping the constraints.

My guess is that it will take a lot less time to get around the regulatory structure that is now under construction. The reasons for this prediction are the three topics that I mention above. In fact, one could argue that the government is doing a pretty good job right now, while you read this post, of conforming to the issue raised in first of the topics.