Credit scoring has greatly reduced the cost of credit to the benefit of industry and borrowers, and has minimized concerns about intentionally discriminatory underwriting. Despite these gains, there remain questions about the integrity of the data used to determine borrowers’ scores and the fairness of the models used by credit reporting agencies (CRAs). These concerns are amplified as credit scores take on increasingly important roles in the society. Indeed, they have become a form of collateral. In this post, we muse about areas in which credit scoring needs further investigation.
Credit scoring unquestionably predicts borrower creditworthiness; however, scores could be more accurate and, thus, more fair. In particular, there is evidence that: (1) there are errors in the inputs on individual consumers; (2) some of the variables and the weights given to them are not predictive; and (3) models omit variables that would help predict borrower creditworthiness. For example, medical debt is often treated the same as credit card debt in scoring models. As a result, borrowers with unexpected, delinquent medical debt will be “dinged” on their credit reports just as people who took on debt buying discretionary consumer goods.
The Consumer Financial Protection Bureau’s bailiwick includes the authority to write rules that would further the purposes of the Fair Credit Reporting Act. The CFPB is already collecting credit report information on 200,000 individuals from each of the three major CRAs for the purpose of analyzing variations between the scores sold to consumers and those sold to creditors (http://www.consumerfinance.gov/wp-content/uploads/2011/07/Report_20110719_CreditScores.pdf). These efforts could expand to include requiring that CRAs and entities, like FICO, that develop scoring models provide the CFPB with their algorithms, including the inputs and the weights given each variable. This would enable the CFPB to test how well the CRAs predict default risk and the accuracy of their inputs.
The three national CRAs are not the only entities that collect and sell data on consumers. Smaller enterprises collect discrete data on individual borrowers that are not necessarily captured in traditional credit scores. Another role of the CFPB should be to identify these providers, evaluate their methods, and subject them to regulatory oversight.
There is a need to understand the market for the provision of accurate credit scores. In a well-functioning market, you would expect that competition among CRAs would lead to ever more accurate credit scoring models. However, if the marginal gains from: (1) including omitted, predictive variables, (2) insuring the accuracy of data with precision, and (3) scrutinizing weights, is small relative to the efficiency of slightly more crude scoring, CRAs and their clients might prefer the latter course. The result would have a potentially adverse impact on borrowers who are at the cusp of creditworthiness, which would implicate fairness concerns.
With lenders increasingly cautious about granting credit to people with less than pristine credit scores, there is a need to survey and evaluate models other than traditional scoring. This should include approaches taken in other countries, with an emphasis on programs that help low-income borrowers build credit and demonstrate creditworthiness.
I am sure there are other areas in which more understanding is needed and hope people will comment on this post so I can expand my catalog.
Stay tuned: Suffolk Law School Law Review will have a special issue on credit scoring and reporting later this year. (http://www.law.suffolk.edu/highlights/stuorgs/lawreview/index.cfm)
The debate about the legality of Richard Cordray’s appointment to head the Consumer Financial Protection Bureau is just one of many brewing power battles. Another, and the one I am writing about today, is the Office of the Comptroller of the Currency’s preemption ruling.
The OCC has absorbed the Office of Thrift Supervision and, thus, has dramatically increased the number of institutions subject to its enforcement, supervisory and rule-writing authority, which translates into more and louder voices crying for preemption of state lending laws. The OCC already is a poster child for regulatory capture because of its 2004 blanket preemption rule shielding national banks from state laws that were aimed at curtailing costly, unaffordable loans, and deceptive lending practices. It was in response to the OCC preemption rule (and a similar one by OTS) that the Dodd-Frank Wall Street Reform and Consumer Protection Act included provisions aimed at limiting preemption.
Dodd-Frank restricts OCC preemption to situations in which a state consumer financial law: (1) discriminates against national banks in favor of banks chartered in the state; (2) “prevents or significantly interferes with the exercise by the national bank of its power;” or (3) conflicts with federal laws that expressly preempt state laws. Dodd-Frank also requires that any preemption determinations be made case-by-case, based on substantial evidence, and on the record. http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_public_laws&docid=f:publ203.111.
As many of you know, on July 21, 2011, the OCC revised its preemption provisions as required under Dodd-Frank. http://www.occ.treas.gov/news-issuances/news-releases/2011/nr-occ-2011-97.html. Many features of the new OCC rule were in accord with Dodd-Frank’s mandates, but the process that the OCC employed in issuing the rule did not follow the requirements set out in Dodd-Frank.
The OCC did not look at individual state consumer financial laws to determine whether they were preempted on the grounds that they “prevent[ed] or significantly interfere[d]” with national banks’ exercise of their power. The OCC’s position is that the process for issuing preemption rulings is only for prospective rules and that the agency had no obligation to review existing rules. As a result, the OCC kept intact a list of preempted state laws that it had assembled under its former and broader preemption standard. The effect boils down to continued field preemption of state consumer financial laws.
So, why should we expect a battle ahead? When the OCC issued its proposed rule, both the Department of the Treasury—of which the OCC is an arm—and the National Association of Attorneys General opposed the proposed rule. The OCC did not yield. Bets are that Obama’s nominee for Comptroller of the Currency, Thomas Curry, won’t yield either.
Whether Treasury and the CFPB, with Cordray in the driver’s seat, will try to win Curry over is hard to say. The CFPB has its own preemption battle to contend with as consumer advocates protest its interim rule on the Alternative Mortgage Transaction Parity Act, which preempts state laws that restrict nonbank lenders from making loans with balloon payments and other “nontraditional” features. http://www.nationalmortgagenews.com/nmn_features/criticize-cfpb-preemption-1028266-1.html.
The field of play will be the courts where state Attorneys General will likely try to enforce laws that are subject to earlier OCC preemption rules. It will take years for courts to determine the legality of the OCC’s process and its 2011 rule. While the courts sort out these issues, neither lenders nor consumers will know exactly which laws matter.
So, a million years ago I worked on a few asset securitizations. Our assets were used car loans, which actually have a really high default rate. But there wasn't any used-car securities crisis. But, following the 2008 Financial Crisis, asset-backed securitizations (ABS) seemed extremely dangerous, particularly securitizations of residential mortgages. (If there is anyone out there who hasn't read Michael Lewis' description of the growth of this industry in Liar's Poker, please remedy this right now.) Mortgage-backed securities (MBS) because the "special purpose vehicle" of the 1008 crisis. But what made them so dangerous?
First of all, it was an extremely large market, so when the stress hit the underlying asset, mortgages, it affected a large number of investments, all in the same way. Also, the housing market works in tandem with the economy as a whole, so downturns in the housing market seems very sensitive to stresses int he economy as a whole. OK, but a lot of investments go bad. Why are these special? One argument is that the the underlying assets were a lot worse than the investors thought. First, the incentives of the loan broker/originator to originate a risky loan and pass it off as OK. Then, the incentives of the "securitizer" (a new word from Dodd-Frank) to pass of a bunch of risky loans to investors as OK. Then, the credit ratings agencies did a bad job of rating the securities. Then, the investors who suspected the risk of the asset thought they hedged their risk with credit default swaps, perhaps not realizing that everyone else was swapping with the same, not-so-creditworthy counterparties. So, any reform would at the very least need to fix the incentives of the originators and securitizers and the transparency of the asset. (I'll leave the credit ratings agency reforms to someone else!)
And Dodd-Frank actually seems to hit the nail on the head here. Section 941 requires securitizers and originators to retain a portion of the credit risk for any asset securitized or any slice of a slice of a slice of an asset that is securitized. For many ABS, this will mean not less than 5% of the credit risk. Now, how will this be measured? Not sure. But, I do know that the securitizer/orginator may not hedge that retained risk. So, theoretically, if you have to hang on to the underlying assets, you will be somewhat picky about what assets you securitize. But, here's the kicker. There will be an exception for "qualified residential mortgages." These mortgages will be the least risky, so if your asset pool is made up entirely of qualified residential mortgages, then you are exempt from risk retention.
In addition, Section 941 authorizes the SEC to promulgate new regulations on disclosures of registered ABS, including risks at the asset level or loan level, if the assets are loans. Also, disclosures would identify loan brokers and originators and the compensation system for the brokers and originators. Also, issuers would disclose their level of risk retention. These seem like good disclosure requirements.
One of Larry Ribstein's threshold questions for Dodd-Frank is whether the market would have regulated this better. This could be an empirical question. For issuances of ABS or MBS in the past 18 months, what have disclosures looked like? Have issuers begun to compete by claiming that their underlying loans are particularly strong on various fronts or that the issuer is retaining ownership in the assets or in the risk of the assets. I'm not sure if this market has rebounded enough for us to measure what investors are demanding in bond indentures for these types of issuances, for example.
Erik correctly sensed my wariness regarding the treatment of derivatives under the U.S. Bankruptcy Code and the new resolution authority granted the federal government under the Dodd-Frank Act. (By the way Erik, great job posing thoughtful questions and fostering additional discussion in the forum; thanks!) In my previous post, I noted that both resolution schemes contain exceptions (a/k/a “safe harbors”) for derivatives and counterparty obligations, and I provided a link to Mark Roe’s article concerning potential issues with that treatment. Accordingly, Erik posed the following question:
Michelle: What do you think of Mark Roe’s argument that providing various exemptions in Ch. 11 (from the automatic stay) for derivative counterparties exacerbated the crisis? Did these exemptions warp the incentives of derivatives counterparties to monitor and discipline debtors? Is this a hole in Dodd-Frank?
I generally agree with Mark Roe’s characterization of the derivative exceptions and the need to remedy this problem under the Bankruptcy Code. As it stands, counterparties have the ability basically to dismantle a financial institution by invoking netting, liquidation, termination and other rights under their derivative contracts as that financial institution becomes more distressed and even after it files for bankruptcy. As Erik’s comment implies, the automatic stay, the prohibition against the enforcement of ipso facto clauses and the threat of avoidance actions in bankruptcy generally do not apply to counterparties. As a result, counterparties can protect their economic interests at the direct expense of the debtor and its other stakeholders.
The Dodd-Frank Act incorporates similar exceptions for counterparties and allows counterparties to exercise many of their contractual rights after a short grace period (one business day). Nevertheless, the Act does impose some limitations on counterparties that are uncertain under the Bankruptcy Code (see, e.g., here). For example, the Act restricts the enforcement of walkaway provisions—i.e., provisions that allow the nondefaulting party to suspend obligations owed to the defaulting party or forego any payments due to the defaulting party upon termination of the contract. So perhaps the Act recognizes some of the vast inequality created by the derivative exceptions, but I do not think it goes far enough.
From my perspective, inequality and the resulting consequences are the real reasons for concern. One of the bedrock principles of the Bankruptcy Code is similar treatment for similarly-situated creditors; it helps protect both the debtor and its stakeholders by, for example, ensuring that creditors are not rewarded for high-pressured tactics immediately before bankruptcy and providing some incentive for creditors to work together to maximize their collective return. The derivative exceptions undercut this principle and grant counterparties far greater rights than ordinary secured or unsecured creditors. I recognize that counterparties face challenging issues in a bankruptcy or liquidation scenario, but I do not believe that the burden of those issues should be placed on the shoulders of the debtor and its other stakeholders.
As to Erik’s other questions, I am uncomfortable grading the legislation as I view it as largely incomplete. The extent of its success (and it could be successful at the end of the day) depends so heavily on things yet unknown—e.g., who writes the rules; the content of the rules; and if and how they are enforced. Would I have voted for the legislation? It depends (yes, the dreaded lawyer answer). Analyzing a piece of legislation as an academic versus a politician requires similar yet very different considerations. Among other things, it would depend on the interests of my constituents and what I thought was best for my district. And finally, I will absolutely incorporate the legislation into my fall courses. I think it is important for our students to understand the import not only of this piece of legislation, but also the legislative process more generally, for businesses and consequently their future clients.
I LOOOOVE LOOOOVE LOOOVE this law, every last smelly comma of it. It gets the second A+ I have ever given in my life. Would vote for it with both hands and feet with my eyes closed.
Here are my summary reasons:
- I am late to the forum (deadlines crashing), and someone has to.
- The law is positively pithy and substance-filled next to your average law review volume.
- The law is one heck of a legislative feat in this political climate, if only for how closely it tracks the Administration's White Paper from June 2009 and the G-30 Report from the preceding winter.
- It does some good and no major harm for its central animating theory: systemic risk and macroprudential regulation. (I am with Brett here--and just look at the title sequence.)
- In the Glass-Steagall--BHC Act--FIRREA--FDCIA--Gramm-Leach-Bliley genealogy (which I prefer to the 1933-1934-SOX genealogy, given the animating theory), Dodd-Frank is second only to Glass-Steagall. And Dodd-Frank gets a lot more lovable if thought of as financial modernization, rather than crisis elimination.
- Dodd-Frank took what opportunity there was. Glass-Steagall passed four years after the crash, after every state in the Union had imposed a bank holiday, farmers with pitchforks were storming courthouses, and some cities had 90% unemployment. And this picture of JP Morgan Jr. was scandalizing the front pages. In contrast, Jamie Dimon looks like Clark Gable brooding over coffee in modern-day crisis pulp.
- If Dodd-Frank had surgically addressed the causes and management of this crisis, it would have been fighting the last war. In fact, I wince more where it does just that (e.g., requiring Fed 13(3) lending to be "broadly available" in what is an incredibly concentrated financial sector, Sec. 1101(a), and the ensuing ode to the liquidity- solvency distinction). Even so, I think the law does a serviceable job of looking ahead to where the risks might come from going forward, based on the experience of the last two decades. Will it save us from the next one? Of course not. Will it make it marginally easier to deal with the next one? Probably.
- I think the Fed and the FDIC are both good eggs on balance, and have done well in the law--including the balance of power between them. I am also glad at the relative autonomy of the consumer protection function, which had no prayer embedded in prudential regulation.
- I suspect that the Volcker Rule might put some downward pressure on the size and transaction volume in the effectively insured financial sector. It is fairly blunt and indirect, but then again, it is not like PUHCA and the Tobin Tax were the likely alternative.
- Like many others, I see the rampant delegationism as inevitable. The multitudinous audit and Congressional reporting requirements are meant to compensate, I think. Does this mean new opportunity for capture? Sure. Net more capture? Doubt it.
- I don't mind studies when they preempt goofy law. Others have addressed some of the bigger examples, but for one little one, Sec. 989F mandates a GAO study of person-to-person lending (think Prosper, Kiva) with a view to potential regulation. This sector is growing super-fast, has tremendous domestic and international development potential, and fits badly in the existing regulatory structure. When Kevin Davis and I tried to think this through last winter, we found no systematic studies to guide the way. Yet the House had twice proposed a provision that would have the consumer bureau regulating P2P platforms, which basically addressed a specific SEC enforcement action and offered no predicate or vision for the sector as a whole. Study away, I say.
- In all, I think Dodd-Frank is about making modern diversified and interconnected financial institutions more regulable. This is most explicit in Title I, and I basically buy the way in which it goes about the task.
I mentioned before that one big idea of Dodd-Frank was almost Goldman Sachs. However, over time, the Goldman-specific provisions were watered down or taken out completely. Section 913 seems like a strange compromise on a Goldman-specific idea: imposing fiduciary duties on brokers.
This argument has come up lately a few times with regard to Goldman. First, Goldman testified in front of Congress in April, and was asked about this question. Erik blogged about it and gave a round-up of links to writers and bloggers on the topic of fiduciary duties for securities brokers. Here's another post from Erik on the SEC suit against Goldman (now settled) where Goldman's obvious defense was that it owed no fiduciary duties to its brokerage clients.
So, Dodd-Frank does away with this big distinction between brokers and investment advisors, right? Um, not really. Section 913 almost does. What does it do? Section 913 requires the SEC to study the effectiveness of the standard of care for brokers who give investment advice to retail customers. Study this. Then, the SEC must submit a report 6 months from (I guess) today. Then, the SEC can engage in any rulemaking necessary to address the standard of care. To make this easier, Dodd-Frank goes ahead and amends 15 U.S.C. 78o(k) to authorize the SEC to promulgate rules to establish that the standard of care for brokers giving personalized investment advice to retail customers is the same as that for investment advisers under the Investment Adviser Act. Does this mean that broker fiduciary duty is a foregone conclusion? I'm not sure. Rulemaking, as others have pointed out here, is different from legislating. Broker fiduciary duty might go the way of attorney "up the ladder" reporting after Sarbanes-Oxley.
And, it will only apply to retail customers, who are defined as natural persons. So, Goldman is off the hook. Even if this duty had existed before the Abacus deal, Goldman would not have owed a fiduciary duty to its non-retail client.
UPDATE: Our own Glom Master Larry Ribstein also testified at the hearing mentioned above and tells me that the SEC will follow through and promulgate rules as per Dodd-Frank, creating an identical duty for brokers along the lines of investment advisers. So, this may be a done deal. Larry also reminds me that this debate was going on before the Goldman Abacus suit, which may answer the retail customer question. Here is Larry's response to Erik's April post on broker fiduciary duties following the hearing. Once this is a done deal, there will be some great opportunities for research. In my experience, those who would manage retail customers personal rollover IRAs seem to charge more if you choose a fiduciary duty relationship, so there may be great unintended consequences here.
Christine: What grade would you give to the Dodd-Frank provisions designed to make sure the SEC doesn’t drop the ball with future Madoffs? Do the provisions, including the bounty, ensure the SEC does the enforcement job it already has? Are there lessons for making other financial regulators more accountable and diligent? Are you worried about overzealous enforcement now?
I hate to say this, but I think Ponzi schemes are inevitable. Teenagers will always tell each other they love them to induce them to act in certain ways, and con artists will always be there to offer you unbelievable returns. Regulating against human nature is impossible. We have murder laws, but we'll always have murder. So, the question is can any regulation help the SEC spot the Ponzi scheme before people lose money.
First, Ponzi schemes aren't really illegal until someone doesn't get their money back. Perhaps the schemes (like Madoff's) where he claims to make an investment and then doesn't do anything at all could be prosecuted prior to its collapse, but it would be hard to do. Or, if someone holds himself out as something he isn't -- broker, investment adviser, etc. or offer an unregistered security. Sometimes the SEC finds an ongoing scheme and in investigating, gets the target to obstruct justice or make a false statement, but usually someone has to lose money and complain about it first. So, pretty much someone has to lose money before we can step in and prosecute. So, it's hard to write any new SEC procedures that will prevent at least some loss.
In Madoff's case, there would have been some losses no matter when an investigation brought the scheme down, but fewer than in 2008 presumably. But, someone at the SEC would have had to take complaints seriously. Ironically, having a bounty system may create a greater number of credible complaints, leading the SEC to view them all with skepticism (a sort of market of lemons problem). Remember, one of the reasons that the SEC was skeptical of Markopolos was because he wanted a reward. Whistleblower protections may induce credible complaints, but bounties may induce an equal number of non-credible ones.
Madoff was also able to continue for a long time because he was an insider and human nature made the SEC investigators not suspect him. Most garden variety Ponzi schemes are by industry outsiders, and the SEC is very good about prosecuting those low-hanging fruits. Will regulation make SEC individuals rise above human nature? No, but now experience will educate investigators to look out for insiders as well as outsiders.
Finally, Ponzi schemes will always pop up as long as their are people who want to make high returns in a quick period of time. Human nature makes the victims look past red flags, particularly with affinity fraud. Regulation can't really do much about that.
There's lots that could have been better about the financial reform bill - I have my own views on the right way to handle resolution authority, the leverage caps could be stronger (though I think they are coming through the Collins Amendment and Basel III), and the systemic risk regulation council approach to coordinated oversight could amount to precisely nothing. But passing legislation is an exercise in the art of the possible, and the act moves a lot of shadow finance into the light, where supervision is at least possible. It starts down the road of rationalization in insurance, in coordinated supervision, and it embraces the globalization of finance by globalizing many of the rules by which banks must pay. I like incremental reform, and I'm impressed by everything that is there. So I think the President should be glad to be able to be in this picture.
I ask the question not because I believe they are warranted, but rather because we have been discussing comparisons between this new Act and Sarbanes-Oxley and those comparisons got me thinking about one striking difference between the two acts in terms of the emphasis on criminal sanctions. With Sarbanes-Oxley, there was a lot of discussion about the need for personal accountability, which ultimately translated into a push for increased liability for corporate executives, and hence provisions imposing enhanced criminal penalties related to various frauds, including sanctions for executives' false ceritification of financial reports. This time, such a push has not been a central focus of reform efforts. In fact, even though this new Act uses the term "accountability," it does not even have the same connotation as it did under Sarbanes-Oxley. Which raises the question, why not? Here are some possibilities.
1. Perp Walk Fatigue. Certainly the debacles associated with Enron and other corporate giants featured a lot of "perp walks" as evidence of the government's efforts to curb misconduct. Perhaps the American public no longer has the appetite for such perp walks. Indeed, perhaps the fact that the first criminal case of executives accused of conduct stemming from the financial crisis ended in acquittal reflects this lack of appetite. Of course, it also could just indicate that the complexity of this current crisis does not lend itself to the kind of criminal prosecutions we saw last time. Moreover, it suggest that the perp walk may not have the same impact in the context of this current crisis, and hence reform efforts cannot have the same emphasis.
2. All Out of Sanctions. In light of the emphasis on criminal sanctions under Sarbanes-Oxley, perhaps the lack of emphasis in these new reforms suggest that we already had reached a ceiling, or close to a ceiling, with respect to increasing criminal sanctions in this area--and hence there was no new ground to cover. Of course, one can argue that this potential did not stop us before. That is, many people criticized Sarbanes-Oxley precisely because it appeared to impose additional penalties related to conduct for which penalties already existed.
3. Been There, Done That. Another possibility is that we have come to realize that enhanced criminal sanctions have a limited impact in terms of their ability to prevent corporate fraud and other forms of misconduct. Indeed, one could argue that the fact that our last reform effort focused on enhanced penalties, and yet failed to prevent this current crisis, suggest something about the utility of such a focus. To be sure, given the complexity of this current crisis, drawing such a conclusion may be entirely inappropriate, but it nevertheless may have played a rule in the relative de-emphasis on criminal sanctions under this new Act.
4. Once Bitten, Twice Shy. Then too, it could be that the Supreme Court's reaction to the use (and some would say over-use) of criminal sanctions in cases like those involving Arthur Andersen and Jeff Skilling, has made us reluctant to rely on such sanctions.
5. No Bad Guys (or Gals), Just Bad Companies. Another possibility is that, unlike before, there are no clearly identifiable executives accused of wrong-doing who have become (or can become) household names. And perhaps the fact that we cannot pinpoint many bad guys (just the bad companies) makes it hard to utilize the criminal sanction process. This observation also could just confirm the broader nature of this crisis as opposed to the one Sarbanes-Oxley was aimed at tackling.
Whatever the reason--and I am sure people can think of more--it does seem like one stark difference between Sarbanes-Oxley and this new Act is the virtual lack of emphasis on enhancing criminal sanctions. I am not sure if that is a theory or theme, but it certainly struck me as a key change.
Erik asked me to answer my own question: Are shareholders the problem or the solution? Here's my stab at it. I enjoyed Renee's question, What's the big idea behind Dodd-Frank? Christine's makes a good case for Bernie Madoff as the animating principle behind some sections of the Act. I'd argue "Shareholders to the rescue" is the big idea behind kitchen-sink Subtitle E of Title IX: Accountability and Executive Compensation. Proxy access, say-on-pay, and even disclosure requirements are about keeping the feds from telling corporations what to do substantively and just giving shareholders a chance--a chance to vote, a chance to know more about what corporations are doing. Brandeis' spirit is alive and well, at least in this subtitle.
But, as I've been thinking about in response to thoughtful and persistent questions from Vice Chancellor Strine, if the immediate shareholders of a corporation (mutual funds, hedge funds) are in it for the short-term, why expect them to care about the long-term health of corporations or act in their long-term interests? The "corporations are bad because they serve greedy shareholders" story (see BP) resonates deeply with the same populist sentiment behind Section 953's mandated disclosure of the ratio of CEO's pay to median employee pay. But the stories are fundamentally contradictory: one allies manager and shareholder together against the rest of us, and the other pits manager against investor.
Which is right? A greedy, myopic shareholder might well want a greedy, short-termist CEO at the helm of her corporation, as long as their interests are aligned via pay for performance. On the other hand, I'm mindful that proxy-access opponents, in particular, have often wrapped themselves in a mantle of virtuous long-termism that by another name smells like management entrenchment ("oh, those myopic shareholders, no understanding of delayed gratification, always in it for the quick buck! Why can't they leave me alone? Will I miss my 3:00 tee-time?").
Are shareholders the problem or the solution? I'm still mulling. But it's hard to see how they can be both,and that's what the populism behind financial reform seems to want them to be.
Erik asks us how we would grade the Act as a whole, and whether we would have voted for it. I seem to be more of a supporter than most posters here: I would certainly have voted in favor, and I give it a solid B. Unlike Renee, I think there is a big picture story which helps identify the core provisions. After decades of deregulation, our financial system has become unstable as players loaded up on leverage and untested innovations, leaving the system vulnerable to episodes of panics and deleveraging which can bring down the entire economy. There are two complementary stories of leverage and systemic risk. The too big to fail story focuses on financial giants whose failure would rapidly spread to dozens of other connected firms. The shadow banking story focuses on the ways that markets like repo, commercial paper, and money market funds resemble banks, with short-term debts financing long-term assets, and hence become subject to runs. A major side story is the housing market, where the main bubble that led to the panic occurred. There, securitization and abusive credit products helped create the dubious debts which eventually ignited the system.
The core provisions for addressing system instability are Titles I and II. We addressed the banking system in the 30s with 3 main elements: deposit insurance, FDIC resolution authority, and increased banking supervision. There's no explicit insurance in Dodd-Frank, but the bailouts suggest that the federal government stands ready to prop up a failing financial system. Title II replicates something close to FDIC resolution authority for a broader range of financial institutions. One element of Title II that I really like is its push to punish the officers of failed companies, through firing and restitution. That may go a decent way to mitigate the moral hazard caused by the bailouts. Title I extends supervision, including regulation of leverage, to a broader range of companies. It should at least cover the too-big-to-fail companies. It doesn't break them up, but it does direct regulators to impose heavier burdens on those companies, and gives them the power to break them up if they believe doing so is needed for financial stability. Title I will probably do less to address smaller companies in the shadow banking system, though as I've noted before that depends on how aggressive the Council is in interpreting its authority. Title IV (hedge fund advisers) should at least give regulators more information about what is happening in many companies within the shadow banking system. Title VII address another important source of financial instability, swaps with their counterparty risks that create doubts throughout the system. The creation of derivative clearinghouses is likely a good idea, although it creates its own risks, and as always the devil is in the details.
Dodd-Frank also addresses the problems in the housing market. Title X creates the Bureau of Consumer Financial Protection. Consumer protection and safeguarding financial stability are sometimes in serious tension with each other. But, abusive credit products can ultimately lead to bad debts that cause problems in the financial system. That is particularly so when originators sell off many of those debts through securitization, reducing their incentives to make sure loans will be repaid. Who knows how aggressive the Bureau will be (Elizabeth Warren for Director!). This idea may not work, but it's worth a try. Title IX Subtitle D adds a 5% credit risk retention requirement for securitizations. Again, I'm not sure it will work, but it's a serious attempt to address a real problem. Finally, Title IX Subtitle C tries many tactics to improve the performance of credit rating agencies. Most noteworthy are the extension of securities law liability to the agencies, and even more importantly the directive to remove credit ratings from regulatory requirements of all sorts (see sections 939 and 939A). It's not clear to me exactly how far this goes--to what extent can agencies use credit ratings at all in their various rules? But this could be a very big deal. If you believe Frank Partnoy, a key reason for the success of credit rating agencies is that the many rules using credit ratings have created "regulatory licenses"--institutions buy highly-rated bonds in order to comply with administrative rules. If those regulatory licenses are being eliminated, it may greatly reduce the role of the credit rating agencies.
Those core provisions strike me as serious attempts to address the main problems that the crisis has revealed. There was even more moaning about the banking and securities acts of the 30s, but they created a regulatory framework that helped bring the longest period of financial stability in American history. (And a side benefit for us law professors: this creates lots more work for our graduates over the next few years, and boy do they need it.) Does the Act get at everything? No, but there are good reasons for not trying to do so, one reason being that no one has any really good ideas about how to address some of the deepest problems. Does the Act sustain uncertainty with all its forthcoming rules and studies? Yes, but I argued yesterday that the alternatives aren't any better. Will there be some bad unintended consequences that need to be fixed? Of course, but doing nothing would probably be even worse. We have a vast, unstable financial system which no one really understands in anything like the depth required to adequately regulate it, and yet unregulated it is likely to drive us into a Second Great Depression one of these days (and there's no good reason to think that the First Great Depression is as bad as it can get). There are no good alternatives available. Given all that, I think Dodd-Frank is quite a reasonable stab at an impossible task.
Once again, Erik is pushing us all on our earlier posts. He asks me:
Kim: Congress seeking to take credit and shift blame is not unique to financial regulation. It happens all the time in national security. What to do? Are reforms to the legislative process in order? Is it the job of courts to hold Congress’s feet to the fire? Maybe strike down overbroad or vague provisions and send them back to Congress? Or is that too draconian?
Not only is responsibility-shifting legislation not unique to financial regulation, it appears to be relatively less common there. Legislators are reluctant to cede control over policy that permits a narrow tailoring of benefits to constituents (including a narrow tailoring of exemptions from legislation). Most of the time, financial regulation appears to provide exactly these sorts of opportunities.
But, as always, there are exceptions. For example, the legislative history of the PSLRA (detailed by Grundfest and Pritchard, as well as by Baker and me) suggests that Congress left the "strong inference" provision of the Private Securities Litigation Reform Act of 1995 strategically incomplete. But, two extremely powerful interest groups--trial lawyers and issuers of securities--were on competing sides of that issue. If possible, rational legislators might go to great lengths (including delegating responsibility to the courts through vague or ambiguous statutory language) to avoid fully alienating either group.
As I noted in my post yesterday, the political conditions leading up to Dodd-Frank were ripe for a responsibility-shifting delegation. The benefits of financial regulation are widely dispersed and barely noticed and a powerful interest group (financial institutions) has an intense interest in the legislative outcome. But, in the wake of the financial crisis, financial regulation has become a high public salience issue, limiting Congressional options. Whether there is similar evidence of responsibility shifting in Dodd-Frank awaits a detailed review of the legislative history.
So, what to do? Few things in life are too draconian for me, as you should know by now, Erik. We develop a three-part test to determine whether a statutory provision is incomplete for strategic reasons, meaning that lawmakers created an intentionally incomplete statute in an attempt to shift responsibility for the negative impacts of law to other governmental branches (the presumption is that they did not). If all three prongs of the test are met, then the court should penalize lawmakers by holding that the provision is so incomplete that it amounts to an unconstitutional delegation of legislative authority. Anyone familiar with non-delegation jurisprudence can easily predict the likelihood (about zero) that the courts would follow this path.
Finally, would I have voted for the Act? If I were a law professor, no, for all of the reasons I mentioned yesterday (sometimes, in my dreams, law professors are invited to vote on important legislation and cases, given free NCAA Final Four tickets, or flown to the Tour de France mountain stages.)
If I were a democratic senator, yes. I would vote for it and give a speech about ending “too big to fail” and restoring American confidence in the financial system. If I were a republican senator, no. I would vote against it and give a speech about how the legislation doesn’t do enough to reign in the big banks or put a stop to Wall Street bailouts.
Dodd-Frank, like Sarbanes-Oxley (and numerous other legislative enactments in and outside securities regulation) before it, includes provisions mandating and permitting specified "studies" of matters not fully resolved by the provisions in the legislation. I often have wondered about these types of provisions. I have more questions than answers.
- Why are these study provisions included in legislation? Is it just congressional guilt about matters not covered? Is there a genuine interest in the outcomes for purposes of follow-on legislation, rule-making, or agency operational changes? Is this a weak attempt at fostering extra-legislative change?
- Are all of the studies concluded? Legislative provisions requiring studies generally set deadlines. Are these deadlines met?
- Who conducts these studies within the appointed agencies? What is their training in empirical research?
- And what ever comes of these studies? Are public reports always issued (since, under mandatory study provisions, reports typically are required)? How often does legislation or rule-making or policy/process modification result?
There are reports on outcomes of SEC studies commissioned under Sarbanes-Oxley published on the SEC Web site. The ones I have reviewed are principally data assembly documents, with no or little econometric analysis. Some include reform proposals. In general, the studies I have sampled don't offer me much comfort that helpful analyses are being performed and used in rule-making, enforcement, or related SEC operations. But I invite folks who know more to disabuse me of that notion, at least in specific circumstances.
The Dodd-Frank legislation includes a general authority provision for SEC studies that particularly intrigues me. The text is included in Section 912, which reads in relevant part as follows:
- Section 19 of the Securities Act of 1933 (15 U.S.C. 77s) is amended by adding at the end the following:
- (e) Evaluation of Rules or Programs- For the purpose of evaluating any rule or program of the Commission issued or carried out under any provision of the securities laws, as defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c), and the purposes of considering, proposing, adopting, or engaging in any such rule or program or developing new rules or programs, the Commission may--
- (1) gather information from and communicate with investors or other members of the public;
- (2) engage in such temporary investor testing programs as the Commission determines are in the public interest or would protect investors; and
- (3) consult with academics and consultants, as necessary to carry out this subsection.
I am not sure why "clarification" is needed here. Doesn't the SEC already (implicitly, if not explicitly) have broad authority to conduct activities related to its rule-making authority? Will this provision be interpreted as narrowing that broad perceived authority? I should hope not.
On a more positive note, it does look like some of us may get some action out of this (or at least the legislation suggests that possibility in referring to the potential involvement of "academics and consultants"). This may give us additional reasons to care about the Dodd-Frank bill on a going forward basis, as we work through our research agendas. Some of the issues discussed in this forum, for example, could (and should) be fleshed out and potentially resolved with the assistance of law, economics, finance, and accounting experts if this provision is interpreted broadly and has real teeth. I still wonder about all that. . . .