Dodd-Frank And The Next Financial Meltdown

This is the last in an 11-part series on the failed promises of the Dodd-Frank financial reform package and the continued, dangerous imbalances in our financial system.
If you have read any of my previous posts, you know I believe Dodd-Frank has failed to achieve its announced objective: to make the systemic changes necessary to prevent another financial meltdown.
Doing nothing to reduce the size of our too-big-to-fail banks has been its greatest failure. We know our four largest banks are bigger and more complex now than they were when we bailed them out in 2008, with combined assets that amount to 97 percent of 2012 U.S. GDP. We must also acknowledge that for the foreseeable future we have nothing in place that would protect American taxpayers from another necessary bailout if one or all of those banks were in danger of failing.
Since 2009, when I co-sponsored a bill with Senators McCain and Cantwell to reinstate Glass-Steagall in an updated form, I have believed that was by far the best solution to the TBTF problem. The bill went nowhere then, and a similar bill introduced a month ago by Senators McCain, Cantwell and Warren will no doubt suffer the same fate. The Volcker Rule started out as Glass-Steagall-lite three years ago. It has been so watered down that, whatever it looks like when the regulators release it in some final form, it will do nothing about TBTF.
We are left with the “Orderly Liquidation Authority” included in Dodd-Frank—weak tea indeed for a number of reasons. Most importantly, that OLA requires agreements across national borders. Yet the G20’s Financial Stability Board has said that international regulators still lack the power to impose losses on creditors and resolve banks without taxpayer bailouts and that “few jurisdictions have equipped administrative authorities with the full set of powers to resolves banks.” Unless and until we make major changes in the size and complexity of megabanks, Dodd-Frank’s OLA is a paper tiger.
Europe is much farther along than we are in eliminating the TBTF problem. Last October, an expert committee set up by the European Commission made its recommendations about bank structural reform. The Liikanen Report said, “The group after reflection came to the conclusion that we needed to do limited separation from the start – to split proprietary trading and market making into a separate legal entity.”
If they had been Americans, they might have called that Glass-Steagall revisited. The overall impact, given the plan’s other recommendations, would be to break up the largest EU banks into entities that were not TBTF.
In England, based on findings in the Vickers Report, Chancellor of the Exchequer George Osborne presented a Banking Reform Bill to Parliament that would separate the retail and investment arms of British banks and erect a “ring fence” around the retail bank so its essential operations continue even if the whole bank fails. Another Glass-Steagall-like solution.
The major argument against reform put forth by both U.S. and European megabanks has been that reducing their size will put them at a competitive disadvantage. The Europeans have more or less said, maybe so, but it is more important to make sure we never again have to bail out a megabank. The obvious answer is for our regulators and theirs to get together and end universal (commercial plus investment) banks. Their political leaders and regulators seem ready. Ours do not.
The only realistic way to end TBTF is to reduce the size of the biggest banks and get something like Glass-Steagall or “ring fencing” on both sides of the Atlantic. After that, we and the Europeans can reach agreement on resolution authority across national borders.
After TBTF, reform of derivatives trading is probably the greatest priority to ensure against another financial meltdown. There has been some progress, but a ferocious battle is currently being fought behind-the-scenes about closing a huge loophole that would allow our megabanks to avoid U.S. regulations by trading derivatives in their foreign subsidiaries. We won’t know until the end of the year who will win, but betting against the bank lobby has not been a winning strategy so far.
Something really ought to be done—although there are no signs that it will—to stop the revolving door between Wall Street and Washington. The latest travesty is the announcement last week that, after what Fox Business said was “the biggest bidding war on Wall Street,” former head of the SEC enforcement division Robert Khuzami has taken a $5 million-a-year job with Kirkland and Ellis, where he will no doubt spend a great deal of time defending Wall Street firms against SEC charges.
The Fed’s announcement earlier this month of rules imposing new and higher capital requirements on megabanks is potentially good news. I say potentially because the rules won’t go into effect until “comments” are received from interested parties before September 7. You know exactly who the most interested parties are, and exactly what side they will be on.
No one disputes the involvement of Fannie Mae and Freddie Mac in the financial meltdown, but nothing had been done to reform them until last month. Senators Warner and Corker have introduced a bipartisan proposal in the Senate and Financial Services Chair Henserling has introduced what he calls a “Republican only” bill in the House. Don’t expect anything but a Mexican standoff in a House-Senate conference if these bills are passed.
Three years after Senators Franken and Wicker proposed a bipartisan bill reforming the credit rating agencies, nothing has happened. Four years ago, billions of dollars of AAA-rated securities turned into junk in a matter of days. There are no signs I can see that anything will happen to prevent that from happening again.

Finally, there is no real prospect that Congress will give any of the regulators the funding necessary to properly regulate the financial industry. The House proposal to cut the IRS budget by 24 percent has raised the most eyebrows, but all agencies face big cuts. There is no real prospect that even a majority of the 398 rules Dodd-Frank required regulators to make will be finalized in the near future
All in all, it is a pretty sad state of affairs—made even more disturbing to me by the recent wave of third anniversary happy talk about the great progress that has been made. According to our Secretary of the Treasury, Jacob Lew, the “core elements” of Dodd-Frank will be enacted by year-end.
Santayana’s famous warning is unavoidable: ”Those who cannot remember the past, are condemned to repeat it.”