In his latest book, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences, David Skeel, the S. Samuel Arsht Professor of Corporate Law at Penn Law, analyses the 2,300-plus pages of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2008, passed into law in the immediate aftermath of the global economic crisis, and representing the greatest financial regulation reform in the U.S. since the Great Depression.
Professor Skeel sat down with Penn Law’s Office of Communications to discuss the impacts and unintended consequences of the Dodd-Frank Act.
Penn Law (PL): Why did you decide to write this book?
Prof. David Skeel (DS): I had been working on these issues for two years by the time the legislation was nearing enactment. I’d been writing articles about the financial crisis, focusing especially on the role that bankruptcy might play and on the regulation of the derivatives industry. I also had talked with a number of Congressional staffers who were involved in the legislation, and had had the privilege of testifying at several hearings on the crisis and possible reforms. Having spent so much time thinking about and discussing the financial reforms, I thought it would be great to put everything together in a book, but I had concluded it would take too long for the book to come out for it really to be worthwhile.
Then in May I got an email out of the blue from an editor, asking if I would be interested in writing a book about the reforms. The good news was that they would publish the book very quickly; the bad news was that they would need the manuscript by the end of the summer.
Ordinarily, my answer would have been, "No way. I can’t write a book in a summer." But it was an opportunity to put everything together in one place, to explain what the legislation would do and what its implications might be. So I took a deep breath and said yes.
PL: What are some of the key issues of Dodd-Frank?
DS: To very quickly put the legislation into context, people talk about the Dodd-Frank Act being an incoherent mess, 2,319 pages of chaos. But it really isn’t. The legislation has two main responses to the financial crisis: first, it tries to limit the risk of the instruments (such as derivatives) and institutions (the giant banks and other “systemically important” financial institutions) of contemporary finance; and second it tries to limit the fallout in the event a systemically important financial institution nevertheless falls into financial distress.
Parts of the legislation actually work pretty well, I think. I think the derivatives regulation is likely to be effective. Lots of other parts of it don’t work so well, and in my view will have unintended negative consequences.
PL: Such as?
DS: The legislation solidifies the status of the largest financial institutions as too big to fail. It singles the giant banks out for special treatment, but it doesn’t try to limit their size or break them up – it just assumes that we’re going to have these giant banks dominating our financial services industry.
I fear that this will have unfortunate consequences. For example, it’s going to be very difficult for small- and medium-sized banks to compete with the giant banks. As a result, I think we may see less innovation in the financial services industry than we otherwise would. We also may well have less lending to small- and medium-sized businesses, because the small- and medium-sized banks are the ones that, historically, have lent to small- and medium-sized businesses.
I also fear that the legislation could create a “partnership” between the government and the largest banks. The legislation contains a number of provisions that could be used to extract concessions from the largest banks, which creates the risk of political policy dictating banking decisions rather than just economics dictating banking decisions. So, one set of unintended consequences has to do with the fact that we are accepting these giant banks and taking them as a given rather than really trying to do something about them.
PL: And what if these giant banks fail?
DS: Well, the second set of concerns has to do with just that. Dodd-Frank’s new resolution rules give regulators the power to take over one of these giant institutions if it runs into trouble. The premise of this system is that what we do with small-and medium-sized banks now is a good model for how to deal with giant institutions when they fail. In my view, this strategy—which gives bank regulators sweeping authority—makes far less sense for giant financial institutions than for small banks. I think that lawmakers should have taken a much closer look at bankruptcy, which relies much less on the discretion of regulators.
PL: What kind of regulatory guidance does the legislation provide?
DS: The short answer is, not a lot. Part of the conventional wisdom about Dodd-Frank is it leaves everything up to the discretion of regulators. This is one context in which I believe the conventional wisdom is right. The new law invites regulators to impose new capital standards on the big financial institutions and even, in theory, to limit their risk taking in a variety of ways. But it doesn’t suggest how to do this. The main regulators are already struggling mightily, and falling behind, as they try to crank out all the regulations that Dodd-Frank calls for.
PL: Why, in your view, is a market-based approach involving bankruptcy a better approach than bailouts?
DS: The danger, in my view, of a regulatory approach to the insolvency of these institutions is two-fold. First, regulators tend to not know that a collapse is coming until it’s too late. Yes, Dodd-Frank is going to help by requiring more oversight and a lot more disclosure. But very frequently, the managers know there’s a problem long before regulators do. So, to the extent you can encourage decision makers who do know what’s going on, such as the managers of the business and its creditors, to make the decision when it's time for insolvency proceedings, as they do with bankruptcy, I think that’s a good thing.
The second concern I have is that there is an inevitable incentive for regulators to bail out a giant institution when there’s trouble. If they don’t bail out one of these institutions and it blows up, that’s egg on their face. Everybody points a finger at the regulators and says: "You dummies, why did you let it fail?" If they bail the institution out, regulators might get some criticism but we typically don’t know until a few years later whether that was a mistake.
That said, I’m not saying that bankruptcy is always the best solution in these situations. Occasionally you do need to inject money into the marketplace. My claim is an argument that whenever possible, it’s better to use a more market-oriented approach like bankruptcy that assures companies aren’t bailed out; and assures that creditors do, in fact, take losses if the company they’ve lent money to does badly.
And in my view, Dodd-Frank pushes things too much in the other direction. It creates, if anything, disincentives to use bankruptcy.
PL: What do you think works about the legislation?
DS: Before Dodd-Frank, derivatives were for the most part simply unregulated. Dodd-Frank now requires that most derivatives be submitted to a clearinghouse, which will be responsible for guaranteeing the performance of both sides of the derivatives contract. Dodd-Frank also requires that most derivatives be traded on exchanges, so they can no longer be secret, private deals between two banks. Now they have to be publicly disclosed and their terms will be a little bit more standardized.
The Dodd-Frank innovation that I like is the new consumer financial protection bureau. The consumer bureau was first proposed by Elizabeth Warren; it was her idea, and as you know she used to teach at Penn Law (although this isn’t the only good reason to support the new bureau!). Supporters of the consumer bureau argued that none of the regulators who were supposed to protect consumers were in a position to effectively champion consumers’ interests. The Federal Reserve, for instance, had primary responsibility but also suffered from a serious conflict of interest. The Fed’s primary mission is to preserve the stability of the banking system, which can directly conflict with protecting the interests of consumers. Sometimes gouging consumers is a way to preserve bank stability.
The beauty of the consumer bureau, in my view, is that it creates a new consumer champion that’s not conflicted, whose primary responsibility is to focus on consumers and to make sure consumers are protected in the financial marketplace.
PL: What will happen if there’s a change in presidential administration, will Dodd-Frank change at all?
DS: The legislation is intended to be independent of a particular administration, in the sense that a number of the key regulators are, at least to some extent, insulated from political changes. For example, the director of the new consumer bureau will serve for five years; the director can’t be removed simply because the party in power changes.
This and other aspects of Dodd-Frank areintended not to be politically sensitive. But in other respects, politics will inevitably play a role. The regulator that arguably came out strongest as a result of Dodd-Frank is the U.S. Treasury, which possesses a number of powers. The legislation assumes that the Treasury will make the first move to take over a giant financial institution that falls into distress, for instance, and a major new research center will be housed in the Treasury. The Treasury, obviously, is very politically sensitive. If we move from one administration to another, we may get a very different Secretary of the Treasury, which will have substantial regulatory implications.
PL: How does Dodd-Frank deal with the international dimensions of financial services regulation?
DL: There is frequent reference to international issues in Dodd-Frank; the word “foreign” appears in Dodd-Frank dozens of times. But when you add all this up, all it amounts to is an exhortation for U.S. regulators to cooperate with their foreign counterparts.
Basically, what Dodd-Frank says is, please coordinate in the event there is financial distress. Dodd-Frank doesn’t do much more than that internationally, in part that’s because there’s only so much a U.S. law can do to deal with international issues.
But even with that caveat, it is surprising that Dodd-Frank doesn’t do more because a lot of what blew up in 2008 did so on an international scale. When Lehman Brothers failed, it wasn’t just a US problem, it was a huge problem in England—in many respects, much more of a problem than in the US; it also was a significant problem in Japan.
Dodd-Frank does do one thing that I think could be very helpful internationally as well as domestically. The new law requires every systemically important financial institution to prepare a “living will,” or “rapid resolution plan,” every year.
The idea is, these big banks have to prepare a fire drill. They have to inform regulators how, in the event of a crisis, they are going to make sure that the damage is contained. In other words, how they will make sure that one bank’s crisis doesn’t become a worldwide crisis.
To the extent this is aggressively enforced, and bank regulators require that the banks prepare a serious plan explaining what the organization of the bank is, and how they’re going to deal with the potential fallout from a crisis, the living wills could actually have a pretty significant effect. It’s the one part of the international response that I think really could make a difference.