Can Dodd-Frank Work?

Dodd-Frank. ... What's your take on it?

... I [personally] thought there were three or four things that if we could have changed would make a difference. One of those was mandatory clearinghouses for derivatives. We don't want to crawl into that rabbit hole and the details, but I thought that was tremendously important and something I'd certainly been for for years. And that made it into the bill.

Two, I thought that it was important that loan originators retained what was referred to as "skin in the game." That got changed in Congress to be loan securitizers. And what skin in the game means is I lend you $100,000, I can't just sell that loan. I have to keep enough of that loan so that if something goes wrong with it, you default, it's painful to me.

In the run-up to 2008-2009, fewer and fewer loan originators were retaining any skin in the game, so if a loan went bad, no skin off their back. If we had had in place a set of rules that made it so that if the lender had to keep some of that, I think lending standards would not have deteriorated to the point that they did. ...

Clearinghouses for derivatives, skin in the game, resolution authority. Those I think, at least in terms of financial stability -- there are other things like the Consumer Protection Bureau which are obviously important for a variety of reasons, but this package I thought would make a difference in the future, and that's all in there. So I think that that bill has made a real contribution to future stability. ...

... Let's talk about Dodd-Frank [Wall Street Reform and Consumer Protection Act]. ... Geithner and Summers are the ones that wrote the original legislation, as opposed to delegating it to Congress, like they did with the stimulus and healthcare. Why is that? And is this bill that was put forward aggressive enough? ...

It's very clear that the Dodd-Frank bill, which was stronger in some ways than the administration's original proposal, does not go far enough, and I think there's almost unanimity among the economics profession on this.

Two issues: One is the "too big to fail" banks. They're still too big to fail. They're even bigger, because part of the process of dealing with the crisis was to consolidate the banks. ...

The second issue is the non-transparent derivatives. [Sen.] Blanche Lincoln's [D-Ark.] committee regulates derivatives, reported out a bill that said that no FDIC-insured institution should be engaged in writing these derivatives. Makes absolute sense. Why should taxpayers be involved in this gambling instrument?

We're not clear whether derivatives ought to be viewed as insurance or gambling. If it's insurance, it should be regulated by state regulators; if it's gambling, it should be regulated by gambling authorities. But neither are banking.

Geithner and Bernanke opposed. Very interesting. Two of the regional presidents of the Fed said this was absolutely essential, wrote a very strong letter.

Bernanke and Geithner won, or to put it more accurately, the American people lost and the New York banks, the derivative-writing banks won, and we are now in a situation where we don't know our exposure to a lot of the risks. ...

They say there's now an ability to, in an organized fashion, dissemble a "too big to fail" bank, that's in the bill. ...

There was what was called resolution authority and living wills, plans for an orderly dissolution.

Two problems with that: One is that the living will describes what you would do in normal times, but in crises, your plan to sell off this asset or that asset or dissolve may not work because there's no buyer on the other side. The markets can actually just disappear. So what does it mean to have a living will when the markets can go into paralysis exactly when you need them?

Even more important was we didn't use the full legal authority before the crisis. The Fed had authority to regulate mortgages, didn't use that authority. The banks scared the American people. They put a gun at their head and said if you don't give us money, we're going to collapse and you'll be sorry, and America blinked. The banks, I think, would do it again.

So even though there's authority to resolve and almost a commitment to resolve, none of us are really sure that it will actually happen if the banks are really too big to fail. ...

Would Congress and would America allow them to bail out the banks again? Is there the political will in this country to allow them to do that again?

... I think there probably isn't. ...

We still haven't seen results in the economy even though the banks have been given billions of dollars to loan. We still have banks that are too big to fail, that are systematically risky institutions. What progress have we made?

There has been progress in raising bank capital levels and requiring that they rely more on long-term funding, so they are more stable from that standpoint. ...

Europe hasn't done much of anything to stabilize their banks.

But we're tied to this banking system. It's all one banking system.

We are. That is true. ... I have done as much as I can -- and probably made myself unpopular with a lot of people in Europe -- to try to bring more public attention to that. Because I don't think the problem with regulatory capture is much worse in Europe in that there is just no separation between the big banks and their regulators. It is a very close relationship and one that I wish the political leadership in Europe would look more closely at, because I think that's a real problem.

But we have made progress. I think the lending standards are better. The Fed did finally move ahead, at least with the high-risk mortgages, and have lending standards across the board.

But we still have "too big to fail."

But there has been progress there too. There are tools to resolve these institutions now. There's been internal planning at the FDIC to be able to put them in a resolution should one of them get into trouble. They are now required to do plans to show how they can be disassembled. ...

... But we still have a system that looks to me [like] we could be back where we were in 2008.

That it could change on a dime? You're right. We absolutely could be.

I think the lack of tangible progress is frustrating to people. I'm not going to say what's happened is near enough. It's not near enough. But in fairness to the regulators, capital is much higher. Liquidity, the funding of banks is much more stable. I think there has been significant improvement there.

We need to be vigilant. They're backsliding already on their funding structure and funding with long-term debt, but there have been improvements there.

Let's talk about Dodd-Frank a little bit. Critics will say that the administration shouldn't have gone with healthcare reform, for instance. When they had the leverage, they should immediately have gone to reregulating Wall Street, to changing the system so that this could never happen again. What's your take on that?

My initial take on that is that we actually accomplished some measure of both. We managed to legislate national healthcare reform. It's not everything everyone wants it to be, I absolutely grant that. There's no public option that many people really cared a lot about for good reason. And financial reform doesn't go as far as lots of people would like it to.

But we've got big noses under both of those tents in ways that no one has heretofore, and how we build on them is really the issue.

… It seemed like for healthcare, for instance, that was handed over to the Congress. Was that the case with Dodd-Frank as well?

I think Dodd-Frank was much more interactive. There was lots of input from Treasury, and then [Sen. Chris] Dodd [D-Conn.] and [Rep.] Barney Frank [D-Mass.] and their committees ironed out lots of the details that ended up in the bill, many of which are still being worked out.

So for example, everyone agreed that we needed to have capital requirements. This was something that was very big for Secretary Geithner, that banks need to have a certain amount of capital on hand, in the vaults, against their liabilities. And yet, the amount of those capital reserves is still being argued about.

When you look at Dodd-Frank, what are the weaknesses, what are the strengths?

… I think the problem with Dodd-Frank is that we traded off getting this critically important legislation over the legislative finish line with not dotting all the Is and crossing all the Ts in terms of the devil-in-the-details part. And now many of those details, which are of great consequence to how well Dodd-Frank works are subject to all the pressures from the lobbies and the politicking that could undermine them.

A lot of people suggest that almost the banks knew that they didn't have to have a big lobbying effort during the actual passing of the bill because they knew they'd have several more bites of the apples.

I think that's right. The fact is that we're having arguments now about key components of Dodd-Frank, and those arguments are not taking place under the scrutiny of the press in the light of day, and the bank lobbyists are in there with big, fat thumbs on the scale. And that has the potential to very much weaken the legislation.

So what can the Obama administration do about that, especially with an election coming up?

The problem with the executive branch is always going to be that you kind of get things over the finish line and then you turn to the next thing.

So I think that this is largely a matter of Congress. To have Barney Frank in the mix is actually very important in getting a good, solid financial reform bill with real teeth. As he retires, that's a real concern. Now, if Elizabeth Warren can come in and play a role, that's going to help. … If both Houses go Republican, one could justifiably worry a lot about the consequences for Dodd-Frank and its ultimate implementation. …

One of the people we talked to was [Financial Crisis Inquiry Commission Chair] Phil Angelides, who did the report that looked into it all. The majority view of the commission was that it failed in some important ways. ... That there was not a real rethinking of the financial markets, that we missed an opportunity. There were a lot of things that were missing. ...

Oh, sure. Look, the regulatory agencies still have an awful lot of work to do to work out the details of what Congress passed. Congress said derivatives that can be cleared have to be cleared; derivatives that can trade on an exchange have to trade on an exchange. CFTC [U.S. Commodity Futures Trading Commission], you go work out the details.

Those details ... are incredibly complicated, and they have a lot of work to do to make sure that those are done right. But it was necessary for Congress to pass the law that gave them the authority to do it.

Same with resolution authority. I think resolution authority is remarkably complicated. I'm not in these discussions anymore, but my sense is they still have an awful lot of work to do to make sure that it's a workable authority.

... Maybe one of the biggest failures is that "too big to fail" banks have not been dealt with. That can was kicked down the alley, and the result is that we are still in a situation where, if we have another crisis, the government is going to be again needing to bail out these companies.

I think that's an easy thing to say. I don't think any of us could know that right now. No one knows what future crises are going to look like.

The "too big to fail" problem is complicated, it's challenging, and defining what's too big to fail is equally challenging. ... But saying it's hard doesn't mean it doesn't have to be dealt with. My sense is there's an awful lot in Dodd-Frank that did deal with this. ...

How hard will these banks fight to stay alive? I've heard $100 million was spent lobbying on Dodd-Frank. They're not going to go down easy.

If someone tried to eliminate you or me, we'd fight pretty hard for our own existence. Again, this isn't that we are bad people. It's the process.

And if you're a megabank, and you operate in say 20 states, you have 40 senators, right? Or if you operate in all 50 states, you have 100 senators. That's the way the process works. These people that run for office -- and I've been there, by the way; I went through a midlife crisis and I ran for public office, and so I understand how it works -- you have to raise money to run for public office. And it expands their power by being as large as they are.

Now having said that, during Dodd-Frank something very interesting occurred. Part of the legislation originally was to take away from the Fed … supervisory and examination powers over the community banks. The original proposal under Dodd-Frank was to have us only supervise the very largest banks, those with $50 billion and larger.

The community banks wanted to have the option to be members of the Federal Reserve System and supervised and regulated by us, as well as by the other regulatory agencies, freedom of choice, and they went to work. It was actually a Republican senator from Texas, Sen. Kay Bailey Hutchinson, who became their champion. She got 93 votes in the United States Senate. And Sen. [Chris] Dodd [D-Conn.], who had made the original proposal, only got six. It shows you the power of community bankers.

Community bankers know, because they bank their congressmen and senators, who they're sleeping with, who's got an alcohol problem, who's got a drug problem, who's good, who's bad, etc. And it was very interesting to see these community bankers sort of rise up and insist that they had a right to be supervised by the Fed, or by another agency, but they didn't want that option to be constrained.

And so I wouldn't underestimate the power of independent bankers. But it is true that these very large institutions are spending a great deal of money, as by the way you and I would as human beings, just to preserve our own existence.

I think your opinion is if we had another crisis and a large crisis, we would end up with the government ending up having to bail out the banks again, despite Dodd-Frank. I think it is an important point to understand what your thoughts are.

Well, under Dodd-Frank, the ultimate decision-making authority as to whether or not to close down an institution or not will be the secretary of the Treasury. That's a political appointment. They work for a president. Whether that president is Democrat or Republican, I don't think matters. …

And what's wrong with that?

Well, you tell me. Do you want politicians to have that ultimate decision-making power? Or do you want the marketplace to have that ultimate decision-making power?

What did we have the last go around? Politicians I guess.

We certainly didn't allow the private market to work its way. Again, I want to emphasize that in the heat of a battle, I think we did the right thing. The point is to not let it happen again.

… The thing that I think you guys brought up, which I think is important, is that if another crisis occurs, it means these banks are going to be in trouble all at once. And that they're all internationally based companies.

Sure, yeah, no, it's not just "too big to fail," it's too many to fail. What you end up with is the roots are interconnected. And you also find, and we've seen this through practice, ... if one risk strategy works, let's say the securitization of mortgages, and you find out it's immensely profitable, it didn't take a genius to figure out that your competitor is going to do the same thing to become immensely profitable.

And so again, with all due respect to Congressman [Barney] Frank [D-Mass.], who is a very able, smart fellow. He has written or has overseen the writing of 2000 pages of legislation, with 541 sections or whatever it is, it kind of reminds me of the French Prime Minister [Georges] Clemenceau's comment after Woodrow Wilson's Fourteen Points. Clemenceau said, "God did it in 10."

And so we've made this thing immensely complex. Sometime simplicity is the greatest virtue, and I think the simplest thing to do here is to just to make sure that we don't have institutions that are "too big to fail." I'm not alone on this front. Paul Volcker will argue the same thing. The head of the Bank of England, Mervyn King, would argue the same thing. ...

Why does the president eventually go for the Volcker Rule? What's the background to that?

… I think in the Volcker Rule, the president just really heard that debate fully fleshed out, both sides, and he made the call. And I think he made the right call. But he really waded pretty deeply into those substantive waters and just made the right call himself.

And Geithner's point of view on it, that he thought it was pushing it too much, it wasn't necessary? Why?

… There are some arguments that it's actually very hard to tell what's the proprietary trading anyway, and what's a bank's book, and what's the book of its customers are not as clear as it used to be. I don't know, none of those arguments made a lot of sense to me.

The Volcker Rule, as Volcker and [Council of Economic Advisers Chair] Austan Goolsbee and others at the time were espousing, was actually a very clear way back to a level of division within commercial banks that made perfect sense to a lot of people, ultimately including the president.

What did the report assert?

The issue is "too big to fail." We have five extremely large institutions that are bigger now than they were before the panic in 2008 and 2009; that they have grown in size, that now have 52 percent of all of the deposits in the United States, and we have had greater concentration of banking power than before all of this started and before Dodd-Frank [Wall Street Reform and Consumer Protection Act]. So the issue is really, how do we deal with "too big to fail?"

Why are they bigger? What happened? I thought this was what Dodd-Frank was about.

First of all, even before Dodd-Frank, in reaction to the emergency of the failure of institutions, they were blended into these larger institutions, assisted by government in doing so.

Dodd-Frank's stated purpose is to end "too big to fail." It's in the preamble of the legislation, and it sets out -- in 2,000 pages and 400-and-some-odd sections -- various ways to deal with financial reform. The focus is supposed to be on making sure the taxpayer never again bails out these very large and complex institutions, and the issue is whether or not it will succeed.

Now it set up some new supervisory bodies that deal with different capital requirements for these banks, and by that what they mean is having sufficient depth of capital that if they get into trouble, they can draw on that capital to protect their depositors and to protect the taxpayer from having to go in and bail them out. …

We know the crises will reoccur. This has happened since the Mississippi Bubble and the Great Tulip Mania, or the South Sea Bubble. This is the nature of economies. …

The question is will the taxpayer be held hostage once more if we have such concentration within so few hands? Again, five banks, 52 percent of all of the deposits in this country. Is that healthy or not?

Our thesis in the Dallas Fed [Federal Reserve] is that this is not healthy. … It gives them such enormity of scale and complexity that it is very hard for regulators to penetrate that complexity. And I would argue -- having been a former banker in the real world by the way, not just at the Federal Reserve -- it makes them extremely difficult to manage because of their size and their scope. And risk management techniques, as it is known in the business, has become very formulaic and mathematical.

The old rule of banking was "know your customer." You shouldn't make a loan unless you know your customer, and you shouldn't really take their deposit unless you know their needs. There is no way on earth that these large institutions can know you or me or their corporate customers as they really should.

And there is a last thing, which is it mucks up the process of what we do at the Federal Reserve. We operate monetary policy. The banking system is an important cylinder in that engine. We provide the fuel. All of the cylinders need to work to operate efficiently. When they're struggling with assets that are in trouble -- even when we cut rates as we have done, or add to the money supply, the base, significantly, as we have by buying all of these covering securities -- they don't put them to work as efficiently because they are worried about their own problems when they get into trouble.

So there are several reasons why one has to be concerned about "too big to fail." The question is does Dodd-Frank answer and solve the problem or not?

And remember, we had hundreds of banks fail during the savings and loan crisis. We were the epicenter of that crisis, so we have been through it before. We do believe that it is one thing to say these new capital requirements, these new bodies that have been structured to deal with evaluating whether or not they are capital adequate, it's idealistically and intellectually attractive, but it may well be impracticable.

A better solution, we would argue, at lesser cost ultimately on the taxpayer, is to have these institutions downsized so that not one of them can place our system at peril, or together they cannot place our system at peril should they fail.

And so I guess that's the answer to the question, are we safer?

Well, it's not clear. We don't know yet. One thing we do know is we now have, I use this analogy: It's not really survival of the fittest; it's survival of the fattest. We have five gargantuan, obese institutions. …

Our argument is that it's not healthy to have a few obese institutions. I'd rather have a system where everybody is slim and fit and ripped and able to work their way through the system, provide the capital that's necessary for our business, for our entrepreneurs, for the women and men that run corporate America and also private business, small and large, to do what they do best: take risk, provide the credit for them, let them grow, create more jobs and create more prosperity.

So the white paper comes out, and this launches the Dodd-Frank process. The banks gear up and are busy lobbying at this point. Do they find friends on the Hill? Do they affect that legislation?

They've got a lot of friends on the Hill. They did impact that legislation, absolutely.

This is one of the most powerful lobbies that Washington has ever seen.

It is, and they got too big as part of the market; they got too big as part of the political process.

Gretchen Morgenson's book Reckless Endangerment chronicles what Fannie did, how Fannie got its tentacles everywhere through not just lobbying and campaign contributions and hiring staff and all of that, but also through funded research with academics, with contributions to some community groups.

I think a lot of the big banks took a page from that same playbook. So it wasn't just the PAC contributions which are significant, but it's hiring former members of Congress and staff. It's funding research that supports your position. It kind of comes from you at all directions.

So even in their weakened position with this horrible financial crisis, they still had a lot of influence. And I think also this ideological dogma of self-correcting markets had taken hold and it was very, very difficult to dislodge, even with all these problems that were clearly related to just basic fundamental regulatory shortfalls. ...

If we'd just had higher capital standards for banks and they had mortgage lending standards that applied to everybody, so much of this could have been avoided. ...

Give us a sense of the power of the banking lobby and what it puts you as regulators up against. How does it work? How do they operate?

Well, it is tremendous. First of all, there are these ongoing relationships. Regulators aren't supposed to lobby, and we shouldn't lobby. We provide tactical assistance. We respond when asked our views.

And Congress generally very freely asks for our views, so it gives the opportunity to have a robust dialogue. But there are actual legal restrictions against lobbying by regulatory agencies, so it needs to be weighed into the balance.

Then [there is] also regulatory agency. The only thing we have are the force of our policy arguments. We don't have campaign contributions. We don't have big paying jobs to hire staff and former members of Congress. We don't have any of that.

So if we can't make our policy case -- and that was one of the reasons why I interacted so frequently with the media -- we needed public help on this, because we didn't have money, and we shouldn't, to counter all this lobbying. ... And these lobbying people don't have to disclose their relationships with the banks. …

... The notion out there on the street ... is that the banks have us over a barrel. That the bank lobbyists buy favor in Washington and that regulators like yourself really are at a tremendous disadvantage in terms of making any progress. ...

They have more influence than they should.

The optics are bad, as you would say.

Well, you can't not talk to them. ... And the fact that you meet with them or talk with them doesn't mean that there's something bad going on. You need to get input from a variety of sources to make rules.

But you do need to make sure that it's balanced input, that you're hearing from everybody, not just big banks, and that your decision is based on what's good public policy, not what some big bank lobbyist wants.

So do the big banks have too much influence? Yes. Is it as bad as people think with the regulators? No, I don't think it is. ...

We still have a largely unregulated shadow banking system where great amounts of trading and speculative behavior can go on. Why?

The Dodd-Frank has many good features, and one of them is to lay the groundwork for controlling the shadow banking system. That has not been effectuated as quickly as other rule-making aspects.

Hopefully they will move. There's not as much urgency because the shadow banking system today is constrained by the lack of funding, but sooner or later those disciplines will disappear. ...

Again, no single group of entity bears all the blame, but the real virus of the housing problem was not in the commercial banks; it was in all the mortgage banks and brokers which were basically unregulated, the true exemplars of the shadow banking system.

Many of them are still relatively unregulated.

Most of them are gone because they failed. But the remainder are unregulated. ...

I just want to run by you a couple things that Phil Angelidis said, the head of the Financial Crisis Inquiry Commission. He points to the fact that they made referrals to the DOJ about what they thought were illegal actions, fraud and ethical lapses. And he's concerned that nothing has happened to this point. …

With respect to Phil, who knows his stuff, I think that's another criticism that's been overplayed.

Unfortunately, it's not like any of these banks did anything illegal. It's that they did a lot of stuff that was patently wrong and completely screwed up the global economy in horrible ways. And all that stuff is legal, man.

The problem is a systemic one. When you actually get down to the very granular level of what broke down here, people were getting bank loans that they never should have gotten. And there just was hardly any fraud there. There was terrible underwriting. There was bad judgment. There was way underregulation. There was way too much trust in a system that would mythically police itself. …

The other point that he makes is that his worry is that there was no dramatic rethinking of the financial markets, that the changes were brought about by Dodd-Frank are too little, too late, that OTC derivatives are still unregulated, that transparency is still lacking.

What we need is not some sort of massive transformation of financial markets. I mean, I don't even know what that means. What we need is simple, common-sense stuff that would make sense to everybody. If you're a bank, you have to have enough capital on hand to support your activities in the markets, to support your leverage.

If you're giving somebody a loan, that loan can't be predicated on housing prices defying gravity forever. So we have rules about underwriting.

If you're an investor, you have to be able to see what's going on in the institutions. You can't have a shadow banking system that hides all that stuff.

That's not rocket science. People like Adam Smith have been trying to teach us that stuff for centuries, but economists hypnotize themselves into this notion that these institutions will police themselves, when in fact they're, of course, inherently unstable.

The bottom line on Dodd-Frank is can Washington actually regulate what Wall Street in the end does?

There is a concern that Wall Street will somehow always outflank the regulators. I'm not sure that history sustains that proposition.

When people look at the first part of this century, ... we were really talking about a whole deregulatory environment. So it wasn't that Wall Street could get around regulation; it was that Washington was pulling away from regulation.

In my view, with good regulation, good regulators, it will be extremely difficult for Wall Street to evade, but that has to be comprehensive regulation. We referred earlier to the shadow banking system. You can't have a big segment of the financial system outside of regulatory purview.

What you also need to do is to end a view which is incredibly penny-wise and pound-foolish, and that is to cut the budgets of these regulatory agencies. People don't go into that for the money, but they do need the staff and they do need the resources.

... Looking back at those years, why did we go in that direction so strongly that we put ourselves in this dangerous situation?

It's a terrific question as to why we went to this deregulatory mode. I think it was perhaps hubris that everything had gone so well, and it was a political philosophy for some people. But it was even then difficult to explain and now close to impossible to explain.

... Does Wall Street understand now the need for regulation?

The key leaders on Wall Street do understand the need for regulation, certainly for the right type of regulation, which has to be robust but also enlightened. Regulation for regulation's sake makes no sense.

Dodd-Frank, does it make sense? Will it change anything?

I've always thought that there was both a good Dodd-Frank and a bad Dodd-Frank.

The good Dodd-Frank was the administration's original proposal, which will change things in a number of ways. You will have better capital, better liquidity, better resolution opportunities, some of the systemic risk conductors will be eliminated, a more comprehensive regulatory overview, an office of financial research, many good aspects of Dodd-Frank.

The bad aspects were the add-ons. Whenever you get a piece of legislation like that, it becomes the inevitable Christmas tree to hang all the ornaments on, and there were a number of provisions which I think ultimately will prove to be detrimental. ...