Banking Under the Dodd-Frank Act from The Baseline Scenario

kristy Reforming Global Finance

Banking Under the Dodd-Frank Act
Posted: 22 Jul 2010 03:33 AM PDT

By Simon Johnson

President Obama’s signing of the financial reform bill yesterday does not end our intense debates over banking – rather it just moves them to a new sphere. Instead of arguing about legislation, the next arena is the action (and perhaps inaction) of regulators.

Those pushing for more effective regulation of the financial system are looking for progress along three potential dimensions. The first two – raising capital standards and appointing new regulators – are the most discussed, but powerful interests are blocking real change. The third – tougher and smarter congressional oversight – holds great promise.

First, on key issues – such as capital standards – there could theoretically be a breakthrough in the so-called Basel Process of international negotiations, e.g., in the run-up to the November G 20 summit in Seoul . Some senior US administration officials continue to make bullish off-the-record remarks, but Sheila Bair is sounding a much more cautionary note. And European participants continue to emphasize that G ermany does not want a significant increase in capital for its banks.

The baseline view here must be that the “lowest common denominator” approach will prevail. This was the consensus at last week’s Future of Finance meeting in London – not at all encouraging.

Second, the easiest way to signal commitment to real reform would be for the Obama administration to appoint strong new regulators, with the head of the just-created Consumer Financial Protection Bureau representing the most important symbol of any new reality.

The front-runner for this job has long been Elizabeth Warren – distinguished Harvard law professor, chair of the congressional oversight panel for TARP (the Troubled Assets Relief Program), and thorn in the side of financial companies with abusive practices. In fact, there are many people who supported the banking reforms under the assumption that Professor Warren would get this job – and start the new agency down the right road.

Unfortunately, in remarks earlier this week, Senator Dodd – the outgoing but still powerful chair of the Senate Banking Committee – appeared to rule out Warren . His wording was indirect – implying that she could not be confirmed – but his meaning was clear.

The statement was all the more striking because Warren enjoys a good relationship with leading Republicans, in part because they like her toughness in the TARP oversight role. For example, Senators Bennett and Corker – both members of the Senate Banking Committee – praised her work last September, and Senators Snowe and G rassley have also been supportive in the past. The initiative to block Warren appears to be coming largely from figures on the Democratic side.

All of this suggests it would be excessively optimistic to presume that more effective people brought in to run regulatory agencies any time soon.

The final way in which regulation could actually make progress would be through continued congressional pressure. It is slightly too early to discern the exact contours of what may be possible, but early discussion suggest we will see established a series of revealing oversight hearings in both the House and the Senate.

Just as the chairman of the Federal Reserve Board appears at regular intervals to explain and elaborate on monetary policy, the chair of the Systemic Risk Council (i.e., the Treasury Secretary) may soon be appearing to discuss the level and determinants of risk in the global financial system. This is a central concept for the Kanjorski Amendment, the radical language within the Dodd-Frank Wall Street Reform and Consumer Protection Act that gives regulators the right and the responsibility to break up big banks when they pose a “grave risk” to the financial system.

Such congressional hearings could become a vague or meaningless discussion, of course. But the early indications are that there is likely to also be a great deal of substance, e.g., aboutnew methodologies, global developments (such as in China), and even incidents when major firms with “state-of-the-art” risk management systems manage to lose a great deal of money (e.g., as with Goldman Sachs’ equity trading in the last quarter).

For a foreshadowing of the discussions to come, take a look at the hearing this week of the Subcommittee on Investigations and Oversight for the House Committee on Science and Technology. The focus was on macro models (e.g., start with Robert Solow’s remarks; he is always clear and to the point), but you can see where this is going.

Smart members of Congress will do very well for their constituents – and for themselves – if they pursue these analytical issues hard. No one is happy to just “leave it to the experts” in the Fed or the Treasury – let along the private sector, particularly big banks.

The most cherished notion of Alan G reenspan was probably that the private financial sector will figure things out, and should be left alone as much as possible. It is hard to find anyone today who takes this view seriously.

The issue now is to find legitimate and effective means of congressional oversight, pushing regulators hard to do the right thing: Question Everything.

An edited version of this post appeared this morning on the NYT’s Economix; it is used here with permission. If you would like to reproduce the entire piece, please contact the New York Times.