Saturday, November 10, 2012

Dodd-Frank and Stigler's Ghost

The New York Times finally published  Gretchen Morgenson's article, pointing out that Dodd-Frank enshrines rather than eliminates "too big to fail," though systemic "designation" of "financial utilities" such as the exchanges has been underway since the bill's beginning. Needless to say, this has been my opinion all along.

Today let's move on. I'll label the bigger problem, "too big to fail means too big to compete." TBTF=TBTC. There, we can put that on bumper stickers.

As the Ms. Morgenson figured out, the Chicago Mercantile Exchange is now too big to fail, and will be able to borrow from the Fed and get a bailout. But that's not the big issue. The CME is now too big to compete. Who can now start a new exchange, maybe offering more protection against high frequency traders or other conveniences to customers, and threatening the CME's customer base? Not against a protected "financial utility."

George Stigler taught us that regulators are prone to "capture." Over the years, regulators start to sympathize with the industry they're regulating. Next thing you know, the regulations end up being used to protect the industry from competition. Luigi Zingales' great new book calls it "crony capitalism," emphasizing that it, not too much benevolent government or too much ufettered market competition, is the main characteristic of our society.

This is not an aspersion on the morals of the people involved, who are usually very well meaning. But if you spend most of  your days talking to industry people, not consumers, for your entire career, it's pretty natural to soon get the view that your job is to help industry. And all the "jobs" it provides. You get the idea. If you're living on a government salary, and ties to the regulator will be worth huge amounts in industry when you quit, it's even more natural.

Stigler would tell us that simple, clear regulations, and situations where the regulator doesn't see the same people over and over again, are less amenable to capture. Huge, complex regulations, whose wording gives regulators great discretion, and regulators who see the same people again and again, pose the most danger for capture.  Inviting regulators to spend thousands of hours sitting down with the regulated firms to write detailed complex rules, which deeply affect what those firms and their competitors can do is asking for trouble on a cosmic scale. I don't have to tell you where Dodd-Frank lies on this spectrum.

Worst of all, the main point of Dodd-Frank "regulation" is to make sure that regulated financial companies don't lose money. If the regulators are imposing big costs on the banks and other institutions, but are charged with making sure they don't lose money, how will they possibly avoid structuring regulations to help subsidize the industry and avoid "wasteful" competition, or upstart competitors siphoning away profitable lines of business? TBTF=TBTC.

The "stress tests" are a good example. Will the Fed publish rules for the stress tests, so that banks can know what's coming? No. The Fed staffers know that if they write rules, then the banks will game around them and the tests will always pass.  So, the Fed comes up with something new and interesting for each stress test. The  fact that financial institutions will game their way around rules is what leads to the huge regulatory discretion under Dodd-Frank.

This would be fine..except that billions of dollars are hanging on the outcome. Like whether B of A gets to pay dividends. Really, how long can a small group of Fed staffers stay uncaptured playing a game like that? A regulator with great discretion is the easiest to bend to industry's wishes.

Capture does not happen right away. Zealous young regulators wade in to write rules and fix the world. Capture happens over years of haggling, people moving in and out of industry and regulatory body, networks of friendships and personal relationships springing up. That hasn't happened yet. But if the system is ripe for capture, it would be amazing if this one time in all of history the capture did not result.

I recently toured the Fed's website on financial reform. The Fed is remarkably transparent about all the things it's doing to "implement" Dodd Frank. (Is this a plea, "this is not our idea, don't make us do all this crazy stuff?")  2/3 of the Dodd-Frank regulations have yet to be written.  So grab Stigler's ghost, and let's  read what the Fed is up to.  As you read, think, "How much money is at stake in this rule-making?" and  "could this process possibly get captured?" Also ask, "Just how much of this is absolutely necessary to stop another financial crisis?"
 The Board .. is working on a final rule that….

..defines when a nonbank company is "predominantly engaged" in financial activities; and the terms "significant nonbank financial company" and "significant bank holding company."

..would implement the enhanced prudential standards..

..implementing Volcker Rule requirements that restrict the ability of banking entities to engage in proprietary trading and to invest in or sponsor private equity funds and hedge funds.

...establish margin requirements for swap dealers,… major swap participants,.. …permitting entities supervised by the Federal Reserve to engage in retail foreign exchange futures and options.

…establishes risk-management standards for designated FMUs supervised by the Federal Reserve

…implement the credit risk retention requirements applicable in connection with the issuance of asset-backed securities.

…prescribe regulations or guidelines that prohibit incentive-based compensation arrangements..
I wonder what the CEOs think of that one.
The Board expects to request comment on a proposed rule….

…to apply the Depository Institution Management Interlocks Act to a nonbank financial company designated for consolidated supervision by the Federal Reserve.

…to impose fees on bank holding companies… that are sufficient to cover the cost of supervising and regulating these organizations.
(Stop and read that jaw-dropper again.)
… prohibits a financial company from making an acquisition if the liabilities of the combined company would exceed 10 percent of the liabilities of all financial companies.
… establish minimum requirements for registration and reporting of appraisal management companies.

…implement quality controls for real estate appraisal automated valuation models. 
(Wait. to stop another financial crisis we need to regulate "appraisal management companies?" "Minimum requirements" is clear Stigler-speak for "keep out competitors)
The Board issued rules 
... on stress testing requirements for certain bank holding companies…

…[that] establishes risk-management standards for designated FMUs supervised by the Federal Reserve

…that permit a debit card issuer subject to the interchange fee standards to receive a fraud-prevention adjustment.

,… to implement changes to the market risk capital rule, which requires banking organizations with significant trading activities to adjust their capital requirements … The final rule includes alternative standards of creditworthiness for determining specific risk capital requirements for certain debt and securitization positions,
(There's a whopper of negotiating who gets to make how much money)
..issued reports to Congress on their implementation of OMWI [Office of Minority and Women Inclusion]offices.
If this rule-making is all starchy for you, thanks to the Fed's excellent transparency, we can see what Fed staff actually do all day and who they talk to. These are the first two I picked off the website, honest, no cherry picking:

A Random Sample of a Fed Staffer’s day:
Meeting Between Federal Reserve Bank of New York (FRBNY) Staff and Representatives from Tullett Prebon July 23, 2012

Participants: (deleted)  
Summary: Tullett Prebon and FRBNY staff held a call to discuss bulk risk mitigation services in the interest rate derivative market. Tullett Prebon staff discussed the role such services play in the market and the potential impact of CFTC and SEC proposed rules for trading and reporting OTC derivatives on Tullett’s tpMatch service.
Well, I'm glad the Fed is listening closely to how its rules affect the profitability of specific companies.
Meeting between Federal Reserve Board Staff and Representatives of Citigroup Inc. June 11, 2012

Participants: (deleted)

Summary: Staff of the Federal Reserve Board met with representatives of Citigroup, Inc. (“Citigroup”) to discuss issues related to the proposed rule of the Board and other prudential regulators on margin and capital requirements for covered swap entities and to discuss issues related to implementation of other requirements under Title VII of the Dodd-Frank Act.

The Citigroup representatives discussed their views and concerns regarding the manner in which the requirements under Title VII would apply to overseas branches of U.S. banks, including non- U.S. clients of such branches, as well as related issues regarding implementation, timing and harmonization of global rules. A copy of the meeting agenda provided by Citigroup is attached below.
Again, the point here is not to accuse the Fed and its staffers of malfeasance. All of this rule-writing is required by the Dodd-Frank act, and the Fed website almost apologetically shows the section of Dodd-Frank requiring every measure. All the Fed staff I know are dedicated well-meaning people. Stuck in an impossible system.


  1. I understand the issues you are pointing out, but I am confused as to what specifically you propose. For example, what exactly does it mean in practice to write "clear and simple " rules, who is going to write them and who is going to successfully ensure that the final product is clear and simple?

    1. Lets start with objective, non contradictory and easy to understand rules that any person can understand. This kind of regulations are even more harmful than higher taxes, because at least taxes are objective.

  2. I suspect often that rules are complex so as to permit a lot of behaviour rather than prevent it. Compare the two rule sets:

    1) No-one may carry on a business of banking at all. Period.

    2) If you carry on a business of banking, then you need to hold x% capital where capital is measured by ...

    Rule set 1 is simple, clear, and 100% immune to capture. Ruleset 2 is much less so. I think ruleset 2 is preferable.

  3. Another fine example of the "Residential Speed Limit Board".

  4. Who's worried about the exchanges+? I am not. The exchanges didn't bring down the system. The big commercial and investment banks did.

    I suspect Cochrane is an expert on financial reform, so I would like him to answer the following?

    Is it true that Financial Reform gives the Federal Government the authority to give the death penalty to big banks that threaten financial stability?
    Yes it does. Now why do you think that's a bad thing?

  5. @Sean, because the government shouldn't do it, the market should.

    1. A long time ago, in 2008....

      How fast people forget


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