Monday, February 6, 2017

Dodd-Frank Reform

Dodd-Frank reform seems to be back on the front burner, according to the latest Presidential executive order. At last.

But let us hope it can be done right. Simply pulling down regulations in ways demanded by big banks will lead, I am afraid, to lower capital standards, more debt implicitly guaranteed by the government, and just enough regulation to keep the big end of the banking industry protected from competition and disruptive innovation.

As with much reform, there is a rather detailed and clearheaded effort coming out of Congress, which gets much less attention than it should relative to the Administration's preliminary thoughts. Watch Rep Jeb Heainsarling's Choice Act for Dodd Frank reform. (Speaker Paul Ryan's "Better Way" plan is the one to watch on everything else. Though corporate taxes are getting a lot of news, the personal tax plan is more important.)

The core of the Choice act offers a clever carrot: Much less regulation in return for much more capital.

A reader asked me a while ago how I would deal with the extraordinary complexity of the Dodd-Frank act. I answered that fixing it was easy  -- a trained parrot could do it. Just teach the parrot to say "More capital. More Capital. More capital."  

Which is all to introduce a little essay I wrote that was serendipitously published last week in the Chicago Booth Review, "A way to fight bank runs—and regulatory complexity" It's a much edited version of an earlier blog post, and offers some suggestions on how even the Choice act might be improved. I'd copy it here, but the Booth Review team did such a nice job of formatting it that I'll hope to get you to click the link instead.

(I've been doing this for a while with the Chicago Booth Review, and they now have a page with all my essays.)


The Wall Street Journal covers the issue well, in A Trump-Cohn Financial Rewrite,
Gary Cohn, who runs Mr. Trump’s National Economic Council, told the Journal that Dodd-Frank’s costs and complexity have restrained bank lending. 
True, but dangerous. I hear lots from the banker community that capital requirements restrain lending, which is not true. If the "costs" are costs of capital, we're in trouble.
The better way to prevent a panic is to have simple but firm rules along with high capital standards that make banks better able to endure losses in a downturn. That’s the philosophy behind House Financial Services Chairman Jeb Hensarling’s proposed financial reform, and it’s the direction the Trump Administration should take even without legislation.
But will it? The President signed his directives Friday after meeting with bank executives, and he didn’t help himself politically by praising the “great returns” BlackRock has earned. The point is to help the larger economy, not bank profits.
Especially not bank profits juiced by lots of leverage, which the government will bail out next time around, because "everybody knows" it was a huge mistake to let Lehman go under.
As a Goldman Sachs alum, Mr. Cohn has a particular burden not merely to relax regulations that are the bane of big banks while doing little to relieve the burden on their smaller competitors and tech start-ups. J.P. Morgan’s Jamie Dimon and Goldman Sachs’s Lloyd Blankfein have argued against a wholesale repeal of Dodd-Frank, which has given these large incumbents a competitive advantage.
As I warned above.

There is a huge difference between knowing how to run a bank -- Goldman Sachs, say -- and knowing how to run a banking system, or an economy.  Banks hate competition. Economies love it. We have seen this failure many times before when successful bankers or businesspeople move to government.  I hope Mr. Cohn can quickly put on a different set of goggles.
Although Mr. Cohn said the U.S. has the highest bank capital standards in the world, they aren’t as high as they should be. The trade he could offer Wall Street is less burdensome regulation in return for higher capital standards. The banks would then be freer to lend money while taxpayers have more protection against the next bailout. This would have the added political benefit of blunting the inevitable Democratic attacks that Messrs. Cohn and Trump are trying to help Wall Street.
And that is precisely the clever deal offered by the Choice plan.


The Executive Order itself is interesting. (I'm trying to follow through on looking up primary sources, as I became aware in reading about corporate taxes just how much commentary spins on thin air.)

The key part is this
By the power vested in me as President by the Constitution and the laws of the United States of America, it is hereby ordered as follows: 
Section 1. Policy. It shall be the policy of my Administration to regulate the United States financial system in a manner consistent with the following principles of regulation, which shall be known as the Core Principles: 
(a) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth; 
(b) prevent taxpayer-funded bailouts; 
(c) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry; 
(d) enable American companies to be competitive with foreign firms in domestic and foreign markets; 
(e) advance American interests in international financial regulatory negotiations and meetings; 
(g) restore public accountability within Federal financial regulatory agencies and rationalize the Federal financial regulatory framework.  
I notice some key omissions. It does not say that the regulatory structure should be primarily aimed at eliminating financial crises or runs. It lists textbook "moral hazard and information asymmetry" so that's not just to avoid wonkish language.

That would have been helpful. Financial regulation combines (as usual) three goals: 1) stop runs and crises, which are fueled by short-term runnable debt, 2) consumer and investor "protection," an effort of debatable value though more important in an industry rendered less competitive by regulation, 3) transfer money and give cheap credit to political constituencies. Saying the primary goal is 1 would allow a big deregulation effort on 2 and 3.

"Moral hazard and information asymmetry" sound like textbook excuses for regulation. In fact most of the moral hazard and information asymmetry in financial markets are government failures, not market failures. Moral hazard results since the government guarantees bank debts, so banks have an incentive to take too much risk. Information asymmetry is forced by regulation such as rules that they can't use lots of available information in making loans. T

hese words apply to analyses of insurance markets, when customers may know more than insurers, and therefore markets break down. I'm scratching my head to think of widespread "moral hazard" and "information asymmetry" in unregulated bank operations. Are we really worried that people know more about their finances than banks can possibly know, given the ability to mine all your records with impunity (free market information asymmetry) so that nobody can get a loan because only the secret deadbeats apply? Just when did this start being the prime worry about unregulated financial markets? Just what are we talking about here?

Or is this a throwaway line that somebody lifted from an economics textbook so that it wouldn't sound like the Administration denies all regulation is bad? That impulse is good, but a better choice of words might have been wise in an executive order that will be cited for all kinds of both good and mischief.

It says "vibrant" but not "competitive" or "innovative," in the sense of new companies being able to offer new and better products to consumers. Foreign companies are great sources of innovation and competition! US cars are a lot better because of the pressure from Japanese imports, and French smartphones are a lot better because Apple is allowed to sell there. What's good for the goose is good for the gander. Competition in (d) and (e) sounds like pure mercantilism, and an inducement to lower, say, capital standards, and raise implicit guarantees, for existing big banks  to "compete," i.e. extract rents.

It also reads as if nobody had thought about fixing Dodd-Frank before. How about
"(f) Review existing analysis of the Dodd Frank Act, reform proposals, and legislation pending before Congress?" 
But all of this minor whining within the gray area. The refreshing part of the source document is that it is pretty vague, and if someone of my tastes -- or Rep. Hesarling's-- were implementing it, what we want to do could fit in well.  The dangerous part is that another reading is equally possible.


  1. The Wall Street Journal editorial today also touches on the fiduciary rule regarding investment advisers, which Trump included in his executive order. I was wondering if you had any comment on that.

    1. I agree with the journal. It will not get better advice to people, will lead to more compliance costs, more litigation, and more CYA behavior.

    2. In what other specific cases should the fiduciary rule be eliminated? Or kept?

  2. The Choice act presents an interesting gamble. If I was running a bank, I would announce my intentions to pursue the high capital, low regulation option. If the bank's share price jumps enough on that announcement to meet the higher capital requirement, I've won the gamble. If not, I wouldn't try to raise money to meet the requirement, because I don't have any new plans on how I would use that new funding to make profitable investments. Instead I would just back down and say that the announced plans were a lapse in judgment, and we will carry on with business as usual.

    The government's use of the Choice act in this way helps gather more information and sheds more light on the issue of capital regulation than if they simply imposed a higher capital requirement on everyone. And it would be great for us to learn more about an issue that is not understood very well right now.

    1. Anwer,

      Any announcement of pursuing the high capital, low regulation option would likely push bank bond prices up (bondholders are about to be paid) and share prices down (new issuance is coming).

      I think John addresses this, but when doing a leverage ratio for liabilities you need to use the market value of equity and the par value of debt.

      Otherwise, any attempt to hit a fixed ratio of debt to equity can be undone by market forces. You sell new shares to buy back debt, but that only pushes down the market price of existing shares and pushes up the price of existing debt - you get nowhere.

    2. Hmmm Frank I wonder a bit about the asset pricing framework you are using for those predictions. But if I were a CEO I would respect the market reaction to my announcement and back down from any decision that doesn't serve shareholders well. And I'm sure that most bank CEOs think like that today, which is why we don't see banks in the regulated system issuing lots of equity simply to buy government debt (which would easily improve capital ratios).

    3. Anwer,

      "..we don't see banks in the regulated system issuing lots of equity simply to buy government debt..."

      Which is why approaching the debt question from the banking side (instead of the fiscal side) is a silly way to do things.

      Banks are not going to sell equity to buy federal debt - they will simply refuse to bid at auction.

      And so it's up to the fiscal authority (government) to reduce it's own borrowing requirements, which in turn would reduce the banking industry's need for short term borrowing. Banks are maturity transformers at their heart. They borrow short term (including overnight) to lend long term.

      If you want banks to borrow less short term money, then it's up to the federal government to borrow less long term money. See several pieces that I have written that talk about the federal government selling equity securities.

    4. Anwer,

      "But if I were a CEO I would respect the market reaction to my announcement and back down from any decision that doesn't serve shareholders well."

      Not only would you as CEO be notifying your shareholders, you would be notifying federal regulators of your intentions.

      I don't think the off ramp from Dodd Frank to higher equity / lower regulation is a two lane highway that you jump back and forth across as you please.

      Is this what you had in mind?

      2018 - JP Morgan CEO Anwer announces they are going to submit to the Ryan / Trump plan of higher equity requirements in exchange for less regulation.

      2019 - JP Morgan CEO Anwer announces they are going back to the Dodd Frank regulation requirements and buying back shares.

      2020 - JP Morgan CEO Anwer announces they are once again jumping on the Ryan / Trump higher equity requirement bandwagon.

    5. Anwer,

      I have always felt that the whole notion of an "off ramp" from Dodd Frank is a silly way to go.

      Sooner or later we will get banking regulation that has "on ramps", "off ramps", "HOV lanes", "underpasses", "cloverleafs", and every other roadway metaphor that you can think of.

      And this will be simpler than Dodd Frank? Or Graam-Leach-Bliley? Or Glass-Steagal?

    6. Frank I was trying to take people along with me on a thought experiment on how the Choice act might affect strategy choice at an actual bank. And regarding government vs. bank debt: I don't think we can have less of both, because we need someone to produce our information-insensitive transactions media. In the dilemma between inside and outside liquidity, Prof. Cochrane leans heavily towards outside (government-produced) money, with his narrow-banking proposals. And we can think of this as "equity money" because it is based on fiat and not redeemable. Indeed Prof. Cochrane has posted pricing equations to determine its real value.

    7. Anwer,

      "And regarding government vs. bank debt: I don't think we can have less of both, because we need someone to produce our information-insensitive transactions media."

      Regarding the choice between less bank debt and less government debt, my choice would be less government debt for a number of reasons.

      "If the bank's share price jumps enough on that announcement to meet the higher capital requirement, I've won the gamble."

      I am still not understanding here. What have you won? After the share price jumps and your bank meets the capital requirement do you follow through with leaving the Dodd Frank regulatory regime - share price stays elevated - or do you renege - share price goes back to where it was? Are you assuming that this "one trick" can be repeated as you move your bank back and forth between regimes?

    8. Frank I think the promoters of the Choice act believe that the low-regulation, high-capital choice will be naturally attractive and preferable, with the act providing a gentle nudge to this alternative business strategy. But as a bank CEO I need some way to know if the new strategy option is actually viable.

      If I simply issue equity, and use it to buy government debt, then I can definitely meet the higher capital requirement. But if I do nothing with that government debt other than hold it and pay the convenience yield, and no big business opportunity opens up from the relaxed regulatory requirements, then I'm worse off with the high-capital strategy. This makes the bank a takeover target, and the high-capital strategy will be reversed by the new owners.

      But if I test the waters by simply announcing my intention to pursue the lightly-regulated option, and there is a large jump in stock price, then I don't need to issue much more equity (perhaps none at all). I will have generated the capital I need to meet the requirement, by stock appreciation, because investors see that some really valuable new opportunities are available now that I am free from important regulatory impediments.

      If the Choice act is passed, probably all banks will get some bump in share prices due to the value of the real option that they have been given. But there will still be some uncertainty regarding the intentions of management. It will be really interesting to watch how this uncertainty resolves, and that will tell us new things about capital regulation.

  3. Grumpy,

    Minor issues (or perhaps major issues depending on how you look at it):

    1. What form should the equity shares that are required of banks take - voting / non-voting, restricted / unrestricted, dividend paying / dividend free?

    2. How do equity (stock) options affect the debt / equity ratio of a bank?

  4. John,

    I guess my only comment is that banks should not have to be told or offered anything to maintain a lower debt to equity ratio - it's just a smart long term business decision.

    And saying that swapping less regulation (carrot) for less debt relative to equity (stick) is a bit of a misnomer. It's more like saying banks are getting their healthy to eat carrots (more equity) and getting their sweet ice cream desert (less regulation) too.

  5. Dr. Cochrane,

    These are some very interesting ideas for financial regulatory reform and I agree with many of them, though some will require more study on my part. I particularly like the idea of using liquid asset market-based metrics for risk. However, I do have some questions. For example, with regard to your essay linked to above where you suggest using implied market volatility of equity to help calculate the risk of a bank run, how are you calculating implied volatility, given that Black-Scholes doesn't apply to American-style options?

    1. B-S does apply to American style options as well as European style. In fact, early expiration for in the money calls and puts is the ex-dividend date. Go to any B-S online option calculator and you can solve for implied vol. The same applies to Binomial option pricing. Finally, establish a risk neutral conversion and you will see the affect(s)/effect(s) of all six variables in the model.

  6. The 2000 Dot com crash hurt shareholders. No run prone short term debt. Debt bias in the tax code, M and M Theorem, induces more debt in capital structure. Of course the value of an asset is its discounted expected future earnings. As for D/E ratios,instead, why not a Pigouvian tax on excessive run prone short term debt?

    1. Because accepting deposits is part of the banks' business model, and taxing deposits reduces banks' profits and thus their capital as well. If the goal is to reduce the need for bailouts, a Pigouvian tax is counterproductive. At best, it draws the funding for future bailouts from bank depositors, and I don't see how that is much better than simply drawing from tax revenues.

      Banks have such low capital because we live in a part of the world where the demand for deposits has grown more quickly than the demand for loans. We can solve this problem by expanding the banking union to include countries that need bank loans more badly than they need large deposit balances. This is a difficult problem of international cooperation, but I don't see how it can be avoided.

    2. David,

      "As for D/E ratios, instead, why not a Pigouvian tax on excessive run prone short term debt?"

      Because long term debt eventually becomes short term debt as it reaches maturity - unless you actually think a bank can successfully market and sell perpetual bonds.

      Because a bank can issue even more short term debt to pay the taxes on it.
      I am not convinced that a Pigouvian tax would actually limit the issuance of short term debt. Government receives Pigouvian taxes on short term debt and does what with it - bails out failing banking institutions?

      Excessive debt relative to what - all other debt, equity, assets, other?

      How short term is too short - is 1 year considered short term, how about 2 years or 5 years?

      How liquid must the debt be to be considered run prone?

      - Marketable?

      - Transferrable by inheritance, will, or deed for the owner of the debt (It's yours till you die)?

      - Transferrable by legal action (bankruptcy / divorce settlement / etc.) for the owner of the debt.

    3. Frank, fair points. Any tax gets passed on to depositors in the form of higher fees. As for long term debt in cap structure, why not consols? as n approaches infinity, the bond will pay a fixed coupon with no effective maturity date. Runs are exacerbated by mismatched maturities. Do consols ameliorate this? Nice topic for PHD candidates. Still, TBTF is policy. Eliminate that, and the problem is greatly reduced.

    4. David,

      "Still, TBTF is policy. Eliminate that, and the problem is greatly reduced."

      Agreed. Then leverage limits become a survival technique instead of a government mandate.

  7. I'm interested in the choice of words "provide taxpayers protect in the next bailout"

    Shouldn't the goal to be to eliminate tax payer bailout. This statement implies that a ballot will always be necessary.

    1. I cannot find those words.
      I find "while taxpayers have more protection against the next bailout".
      My reading has it saying that there will be less likelihood of a bailout being needed.

  8. On banks: Another KISS solution.

    No regs, but one. Banks must provide privately purchased, privately offered deposit insurance for depositors.

    Now, maybe there is another reg here. The banks must purchase deposit insurance from "licensed insurers."

    Perhaps the US could generate a small pool of national deposit insurers, five or so large outfits, that are licensed.

    We could hope the deposit insurers charge according to risk, and those costs are passed on to depositors, and the market works out the rest.

    One last note: Ultimately, I still think you have to have a central bank available to back-up the deposit insurers, print money when necessary to bail out the insurers. My sense is that private financial institution can be built to weather storms, and maybe really big storms---but not the 50-to-100 year storms of an unanticipated type.

    Sooner or later the insurers will bust. See AIG for clues.

    But a good approach nonetheless.


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