June 17, 2011
Banking Roundtable: Thoughts on Teaching Banking Law in Light of the Financial Crisis and Dodd-Frank
Posted by Erik Gerding

The following post comes to us from Arthur Wilmarth, Professor of Law and Executive Director of the Center for Law, Economics and Finance at the George Washington University Law School:

 Many thanks to Erik Gerding for organizing this exchange of views on teaching Banking Law, and for inviting me to participate. Following are some of my thoughts on teaching Banking Law in the context of the financial crisis and the Dodd-Frank Act:

(1) I use a historically-oriented approach in teaching Banking Law. I spend at least two classes on the history of banking regulation before 1980, with a particular emphasis on the 1920's and the New Deal legislation of the 1930s. I believe that the credit boom of the 1920s, the financial and economic crises of 1929-1933, and the New Deal legislation provide a very helpful comparative context for studying the events of the past decade.

(2) I spend several classes reviewing the expansion of powers for national banks and the expansion of permitted financial activities for bank holding companies (BHCs) before I discuss the financial crisis. We also consider the basic safety-and-soundness regulations for banks (including deposit insurance, capital requirements, prompt corrective action (PCA) and affiliate transaction rules) before we discuss the financial crisis. Evaluating the desirability and effectiveness of limitations on bank and BHC activities as a trade-off for government support helps the students to appreciate policy arguments for and against greater regulation. We also discuss Congress' decision to rely on the affiliate transaction rules under Sections 23A and 23B of the Federal Reserve Act as the best way to prevent the spread of safety net subsidies from banks to their nonbank affiliates (especially securities broker-dealers) following the enactment of the Gramm-Leach-Bliley Act in 1999.

(3) We spend 2-3 classes discussing the banking and thrift crises of the 1980s and the legislative responses to those crises in 1989 and 1991. That discussion helps students to appreciate the limited ability of Congress to respond effectively to the causes of financial crises. In 1991, Congress focused on capital regulation as the best antidote to the moral hazard created by deposit insurance, even though there was already significant evidence that capital rules were undermined by (i) the lagging effect of capital levels as indicators of bank problems, and (ii) the vulnerability of capital rules to capital arbitrage.  Congress also thought it could force regulators to take timely action against undercapitalized banks by enacting the PCA regime.

Instead, however, regulators agreed to the advanced internal risk-based approach for capital regulation embodied in Basel II, which deferred to internal risk models created by the largest banks and allowed them to conceal significant increases in their effective leverage. In addition, when the financial crisis reached its peak in 2008 and early 2009, U.S. regulators announced they would not apply PCA rules against any of the 19 largest BHCs and, instead, would provide any capital those institutions needed to survive. Similarly, the Fed repeatedly waived the affiliate transaction rules under Sections 23A and 23B so that major banks could support their broker-dealer affiliates during the crisis. Thus (as Saule Omarova has persuasively demonstrated in her forthcoming article), regulators decided not to enforce Sections 23A and 23B against the largest financial holding companies just as they refused to enforce the (purportedly) non-discretionary PCA rules.

(4) We spend 2-3 classes on the basic causes of the financial crisis. There is a huge amount of material on which to draw, but I have used two sources in the past couple of years that I have found to be reasonably comprehensive and accessible to students. The first is testimony that FDIC Chairman Sheila Bair presented to the Financial Crisis Inquiry Commission in January 2010. It provides a good survey of the causes of the crisis as well as several proposals for regulatory reform that were ultimately adopted in Dodd-Frank. That testimony can be found on the FDIC's website at the following weblink:

http://www.fdic.gov/news/news/speeches/archives/2010/spjan1410.html.

The second source is an article written by Kenneth Scott entitled "The Financial Crisis: Causes and Lessons." The article is available on SSRN at the following weblink:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1521610.

There are certainly many other good sources that are available on the causes of the crisis.

(5) After discussing the causes of the crisis, we spend 3-4 classes on the main highlights of Dodd-Frank (especially Titles 1, 2 and 10, with somewhat less attention to Titles 3, 6 and 7). Again, there are many useful summaries of Dodd-Frank. None of them is ideal, but I have found the e-book on Dodd-Frank published by Arnold & Porter to be quite good. The e-book is available at the following weblink:

http://www.arnoldporter.com/resources/documents/Dodd%20Frank%20Act%20Compendium%20(eBook).pdf.

In our discussions, we try to evaluate whether the provisions of Dodd-Frank (i) represent promising or misguided responses to the causes of the financial crisis, and (ii) were the product of compromises and concessions that indicate the surprising amount of political influence retained by the major financial institutions despite their shared responsibility for the crisis and the extraordinary governmental assistance they received.

(6) We finish the course by looking at the conventional bank receivership rules under the Federal Deposit Insurance Act, and we compare those rules to the orderly liquidation authority created by Title 2 of Dodd-Frank. We also discuss, more generally, whether the Dodd-Frank has essentially separated the regulation of financial institutions into two tiers, one for non-systemic institutions and the other for systemically important financial institutions (SIFIs) that will be subject to Titles 1 and 2 of Dodd-Frank. I point out that numerous PCA orders have been issued against small and midsized banks, and hundreds of those institutions have been placed in receivership during the past three years. In contrast, Lehman Brothers stands alone in the U.S. as a presumptive SIFI that was allowed to fail. We discuss the policy implications of too-big-to-fail (TBTF) for the future of financial regulation in the U.S., and we evaluate whether Dodd-Frank will do much to reduce the explicit and implicit subsidies received by institutions that are perceived to be TBTF.

(7) As the above discussion indicates, I emphasize history and also integrate policy discussions with regulatory analysis. I believe that the current regulatory structure and the most important regulatory statutes cannot be understood by law students and banking lawyers unless they understand the historical background of those statutes and the policy arguments that led to their enactment. To the extent that our students become regulatory lawyers, they will certainly need to use policy arguments in their future interactions with regulators and the courts. The financial crisis has demonstrated that policy considerations count much more than statutory technicalities in determining how Congress and regulators respond to a major crisis.

Finance, Financial Crisis, Financial Institutions, Roundtable: Banking, Teaching | Bookmark

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