Kim and Larry have raised a complaint that is becoming a standard part of the critique of Dodd-Frank.  The Act requires regulators to write countless new rules and reports.  I say countless, but both point to a Davis-Polk memo which does the counting and finds 243 new rules and 67 studies required.  The uncertainty required by these rules will hamstring markets for years, and motivated financial industry insiders will coopt the rules and studies to their own advantage. Plus, have you heard that the Act is really, really long, over 2300 pages?  The horror, the horror.  I'm just hoping that my coffee table, where I'm trying to work through the thing, doesn't collapse under the weight.

This critique has more than a kernel of truth.  All those forthcoming rules and studies really will create great uncertainty for years to come.  Businesses hate uncertainty, and now when we are struggling to emerge from the worst downturn since the Great Depression is not the time to put new obstacles in the way of investing.  And the public choice critique that this vague bill will allow Congress to claim triumph and leave Goldman Sachs to snatch back victory as the details are written may certainly turn out to be right--that's a point on which observers from all sides of the political spectrum can agree.

But before we declare all those studies and rules an unmitigated disaster, we need to ask what are the alternatives.  For the most part, the studies and rules address truly serious, hard, complex problems.  Should we change the business model of credit rating agencies to avoid conflicts of interest, and if so, how?  How can we make regulations more countercyclical?  What sorts of proprietary trading should we allow banks to engage in?  And on and on.  What other basic strategies might Congress have used to address these sorts of questions?

When in doubt, do nothing.  This is a prescription for laissez-faire, since we are in doubt on almost every question that matters.  Laissez-faire is great if you think markets generally work quite well.  But there are loads of reasons in both theory and history to believe that unregulated financial markets are subject to severe instability.  I have lots of qualms about the bailouts and stimulus, but without them there's a very serious chance we would now be stuck in the Second Great Depression (granted, we may be there anyway, but odds are that we aren't).  Although federal policy played a role in getting us here (low interest rates for too long, Fannie and Freddie, the mortgage interest rate deduction), the central cause is quite clearly financial derugalation and innovation.  This is what financial markets eventually do when given half a chance.

There is a less smiley-face but plausible defense for laissez-faire.  Yes, financial markets are quite unstable on their own, and nasty things like depressions will result if we leave them to their own devices.  But, legislators and regulators are so corrupt and/or incompetent that they are likely to make things yet worse.  So better to live with even deeply unstable unregulated markets.  That's basically what Hayek argued during the Great Depression.  I have a lot of respect for that position, but it's not very popular or likely to succeed, and for good reason.

Go ahead and put detailed rules in the Act now.  That would resolve the uncertainty and make Congress responsible for the outcome.  Problem is, Congress has no clue what to do about dozens of crucial issues.  It lacks the expertise, and not enough time has yet passed to really think through what needs to be done.  If it tried to ignore those facts and just merrily legislate away irregardless, it would very likely make many deep errors far worse than the errors which I am sure litter Dodd-Frank.

Legislate what you can now, and then write further legislation (rather than regulations) later when you have studied it more.  On its face, this seems like a good compromise option.  But it rather fiendishly brings together the worse problems of all of the above options.  The resulting uncertainty would be even worse than Dodd-Frank itself, because one wouldn't know what else Congress might eventually do and when it would do it.  The practical result would probably be laissez-faire on most matters not handled now, since starting in January Congress is likely to be far less open to further regulation.  And even if Congress did write some other laws later on, it would still be plagued with the lack of expertise and corruption that are part of Congressional rulemaking.

But if we are going to leave so much to administrative agencies in the future, how do we ensure that they aren't captured by the industry when they write those rules?  Well, we certainly can't ensure that won't happen, and to some extent at least it will.  But we can try to find ways to cabin the problem.  My post yesterday and my comments to Erik's posts today try think about how to do that.  The Office of Financial Research is a part of it.  Required reports to Congress are another.  Erik's suggestions of ways to involve academics in commenting on proposed rules is another.  Beyond that, we need to explore ways to encourage more vigilant and independent agencies through HR practices in the civil  services (something I think Erik is writing usefully about).  And beyond that, we need to think about whether there are any concentrated interest groups which might help in the fight.  One group to consider is smaller regional banks, which have an interest in seeing a level playing ground that doesn't advantage either the giant banks or the shadow banks.

Adding up the costs and risks from these different basic approaches to how to deal with our lack of knowledge and understanding is really, really hard.  I have no confidence that the Dodd-Frank approach of doing a lot, but leaving even more to later rulemaking has gotten it right.  Given our basic ignorance, it seems unlikely that it has.  But my provisional verdict is that Dodd-Frank takes the worst path available, except for all of the others.

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The Dodd-Frank Act needs a theory.  The Act reads like lots of bits and pieces mashed together to address the various factors identified as contributing to the 2008 financial crisis: derivatives, sub-prime, securitization, etc.  It addresses many of the symptoms of a broken financial regulatory system but fails to restore a workable regime.  What seems to be missing from the Act is an underlying theory of the primary factors that allowed all the smaller problems that the Act addresses to materialize.

In the conventional view, the financial crisis arose because the biggest banks had become too big to fail.  A corollary is that these same firms were too big to regulate.  Their size, resources, importance to the economy and political influence meant the firms could outmaneuver most regulatory attempts to control their conduct.

Despite its breadth, the Dodd-Frank Act fails to squarely address this fundamental problem.  Banks are bigger now than ever and the Act does nothing to change that.  Furthermore, the Act's provisions must be implemented by regulators, many of whom come from the very banks they are charged with overseeing.  This gives the banks and their lobbyists many more bites at the apple to prevent the imposition of regulations they find undesirable.  Add to this, the prospect of litigation challenging controversial rules and it looks as though the banks retain the upper hand in resisting unwanted regulation.

Like the Dodd-Frank Act, Sarbanes-Oxley was an instance of Congress enacting legislation in response to an economic crisis.  Yet unlike Dodd-Frank, the Sarbanes Oxley Act seemed to reflect a grand theory of the underlying causes of the accounting scandals of 2001 and 2002.  The theory can be summarized as follows: corporations and their managers had co-opted auditors and corporate directors were too inattentive, ill-informed and ill-equipped to do anything about it.  Most of Sarbanes-Oxley's provisions address these two main problems: auditor conflicts of interest and ineffective board oversight.  Whether one thinks that Sarbanes-Oxley dealt effectively with these problems, it is fairly clear that that's what Congress set out to do. 

Because the Dodd-Frank Act lacks a central thesis about what caused the financial crisis, it is unlikely to prevent future meltdowns. But by focusing narrowly on the many symptoms of regulatory dysfunction it may well prevent the re-occurrence of those events and circumstances that led up to the 2008 collapse.

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Erik Gerding asks me this question. My answer is that somewhere in the 2000+ pages there must be something, but offhand I'm not prepared to say what. 

What I can do is propose a three part test for finding such provisions:

1. What provisions are likely to make us better off in the long run? 
2. Of these provisions, which would the markets have done a better job handling in the long run?

I should add that even if there are such provisions, I'd still want to know whether they were worth setting in motion the inevitably massive horse-trading/sausage-making process that led to the adoption of so many clearly bad provisions.  In other words, the law must be evaluated as a whole.  

Now you can appreciate my skepticism. 

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Davod notes Dodd-Frank's "wee bit of federalization" in creating a Federal Insurance Office. Although I'm thankful Congress didn't go further and that some jurisdictional competition was preserved, I agree with Dave that the FIO is a move toward greater coordination.  The problem is that without a structure designed to achieve a balance between federalization and constructive competition, I think that state regulation as a whole is likely to "fade away" -- and not just its "idiosyncracies" as Dave suggests. 

Henry Butler and I have proposed a system aimed at improving and preserving state competition while addressing its worst flaws. The system allows insurers to choose a single state regulator, but gives states some power to protect local insureds through legislation. A Federal Insurance Office conceivably could be part of this system by providing monitoring and a threat of federal takeover if the states misbehave. 

There is still time to go down this road.  I hope our proposal gets a full hearing before we jettison the states and end up with another unwieldy federal bureaucracy.

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The administration and lawmakers are busy congratulating themselves on the “historic” Dodd-Frank legislation, the “toughest financial reform” since the Great Depression.  Sure . . . if historic is synonymous with long, costly, needlessly complex, and likely to have little impact on systemic risk, moral hazard, or the financial market opacity that exacerbated the financial crisis. 

Not all of the bill’s provisions are bad, of course, and some may even be good (though much will depend on implementation).  And there is little doubt that the legislation will significantly change the regulatory landscape and business operations of every financial institution and many commercial companies doing business in this country. 

But I join the chorus of those who believe that the bill largely fails to address the root causes of the financial crisis and the financial system weaknesses exposed by it; grants discretionary authority to regulators to perform acts already within their existing powers, such as identifying systemic risks (which they did not use before the last crisis, and are not likely to use before the next one); punts the bulk of meaningful issues to regulators; and fails to address at all items that should have been at the top of Congress’ reform list (such as the credit rating agencies and Fannie and Freddie). The mammoth bill contains by one conservative count 243 items requiring regulators from various federal agencies to fill in the rules about how the law will be implemented and calls for 67 studies to be completed. 

Dodd-Frank is at its most precise when it addresses issues wholly unrelated to financial reform.  For example, it requires each agency (§342) to establish an “Office of Minority and Women Inclusion that shall be responsible for all matters of the agency relating to diversity in management, employment, and business activities,” and “the fair inclusion and utilization of minorities, women, and minority-owned and women-owned businesses in all business and activities of the agency at all levels.”   It further requires workplace flexibility plans (§1067) for the newly-formed Office of Financial Research that include flexible work schedules, domestic partner benefits, and parental leave and childcare assistance. While laudable goals, it’s hard to envision these provisions as the key to preventing impending economic doom. And we banned those pesky Hollywood box office futures.  What a relief!  Surely that will stop the next major financial crisis in its tracks.

As Mike Dorf notes, the media and commenters have, to a much greater extent than usual, implicitly invoked public choice critiques of Dodd-Frank, noting “both: (a) that the bill leaves very important details to be filled in; and (b) that this means that Wall Street banks have the opportunity to gut whatever substantive checks the bill was supposed to provide.”  But the bill was never intended to provide substantive checks, and regulatory capture is only one basis for a public choice critique of the statute. 

The political conditions leading to Dodd-Frank were ripe for what Scott Baker and I have previously termed a responsibility-shifting delegation.  I believe it is this fact, and the obviousness with which Congress sought to accomplish it, that explains the criticisms levied at Dodd-Frank, more than concerns about regulatory capture, which (as Dorf notes) is a ubiquitous phenomenon that rarely receives popular attention.

Statutes, like contracts, can be more or less complete, but will inevitably have some gaps and ambiguities, which courts or agencies must fill.  A purposely-incomplete statute is not necessarily bad. Statutory incompleteness may allow lawmakers to harness the expertise of courts and agencies, provide the flexibility to adapt the statute to changing circumstances, or reduce the transaction costs associated with lawmaking. For this reason, one tends to observe relatively more congressional delegations in highly technical areas that require much expertise and information and in which technology may change quickly.  Financial regulation fits this description on many fronts.

But lawmakers may also leave statutes incomplete for strategic reasons.  When a statute is particularly salient to organized interest groups, the voting public, or both, lawmakers may find it politically advantageous to delegate to another branch of government the authority to fill statutory gaps and ambiguities in an attempt to shift responsibility for the negative impacts of law to other governmental branches.  For example, empirical study has shown that Congress delegates more frequently in issue areas where it may be hard to claim credit for any benefits of regulation (because they are widely dispersed or barely noticed), but mistakes can be salient and catastrophic, such as drug and product safety, workplace safety, and nuclear weapons.  Alternatively, delegation through an incomplete statute may benefit Congress when powerful interest groups are at odds over legislative language, or when the general public’s preferences diverge from those of powerful interest groups on a matter of high public salience.

The benefits of financial regulation have historically been, and continue to be, 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 – an issue of traditionally low public salience -- has been transformed into an issue about which the public cares deeply, yet has little expertise or knowledge by which to judge the success of legislative outcomes.  This renders the Dodd-Frank responsibility-shifting statute almost predictable. 

Congress will receive scant credit for good lawmaking if the financial system stumbles forth with no mishaps and much blame if it does not – like airplanes, we have come to expect crash-free financial systems, and seek someone to blame when they do. Dodd-Frank promises Congress the possibility of claiming credit for meaningful financial reform through public-interest rhetoric about “ending to big to fail” through a lengthy, complex, and “historic” statute, while blaming court interpretations and agency implementation as the cause of any errors. When viewed in these terms, a financial reform statute with more meat seems almost foolish from a Congressional perspective.

I wish that I could share Dorf’s optimistic view of Dodd-Frank as a public choice “teaching moment” – now alerted to the possibility of regulatory capture, the public will be less likely to allow it in the future.  But because statutory incompleteness is such a noisy signal, it is likely to remain an effective tool for lawmakers. Voters, able to observe only the fact that an incomplete statute has been enacted, and unaware of Congressional motivations, find it difficult to differentiate welfare-enhancing incompleteness from responsibility-shifting incompleteness.  This is particularly true in an issue area, such as financial reform, where delegations will be welfare-enhancing with some frequency, due to the high transaction costs associated with legislating with specificity, the complex and technical nature of the issues involved, and the need for ongoing flexibility. Unfortunately, ill-informed voters are left unaware of the rules of this game, permitting legislators to blame courts and agencies when later interpretations appear to undermine legislative mandates. 

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Since it is always a treat to get so many professors together to talk about financial regulation, let me pose a few questions to the forum participants based on their posts:

Brett: You point out that the too-big-to-fail concern misses the systemic risk of many smaller institutions engaging in herd behavior. What can we do about that? Is this a huge hole in the bill? You also write about Title I extending regulation to non-bank financial companies. Do you think this section is particularly prone to legal challenge? What would make the Financial Stability Oversight Council and the Office of Financial Research more effective in spotting new risks?  Does administrative law have anything to say? (Perhaps we can entice David to address these questions too.)

David: Should bond insurance be treated differently in terms of the federal/state divide?

Christine: Do you buy the stated premise of the executive compensation provisions that compensation led to excessive risk taking and contributed to the crisis? If so, is there a better way to address the issue? Why do lawmakers love clawbacks rather than pushing companies towards restricted stock? Requiring that executives hold on to stock would have many of the same benefits of clawbacks, but with less messiness of potential litigation and other transaction costs.

Gordon: Is there any argument that an over-inclusive definition of “accredited investors” played a role in the crisis? Or is this just “might as well put one more item in the shopping cart rather than make a separate trip”? Are you suggesting we re-think the net worth = sophistication premise of the accredited investor standard? You write: “perhaps we ought to find out which investors, if any, benefit from the disclosure system before we set these thresholds.” Where would we begin?

Larry: What would you have done had you been writing the reform legislation? Is there anything in the bill you would keep?

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The financial reform fight isn’t even half over. We’ve left the headline news period and now move to the rulemaking end of the sausage factory, and there is a lot of sausage to be made. Expect some offal results.

What else do you expect when the issues are highly technical and there is a highly uneven playing field. It doesn’t take a public choice expert to point out that an interest group facing higher stakes, with smaller numbers of participants and more homogenous interests, and possessing greater resources has an advantage. If a particular regulatory issue pits two segments of the financial industry against one another, perhaps there will be some payoff from interest group pluralism. When an issue pits the financial industry against a large group like consumers, who would you bet on? There are many ways consumers can lose – and not just with weak consumer protection laws. Often, regulatory capture results in more rules not less, however, the objective of the rules is not to help the public but to create barriers to market entry.

So the real problem with an independent Consumer Financial Protection Agency is one of basic political economy: who is its constituency? In the short run, it may have really stellar leadership. However, in the long run, pitting consumers against lenders may seal the fate of the agency. I don’t think it is going too far on a limb to predict that this agency will be hamstrung by this imbalance for all of its history.

A similar imbalance will afflict much of the rule making in the wake of Dodd-Frank. Who will make most of the influential comments on these rules? Law firms and trade groups paid for by financial institutions who are – surpise – self-interested. We can tut-tut about this, but that’s part of our regulatory landscape.

I wonder though if there is a way to get law professors more involved in the regulatory process to act as a counterbalance. Many professors contribute to amicus briefs and testify before Congress, but commenting on regulations seems rarer. Commenting on regulations may not be recognized as scholarship or service, and it requires a lot of time and expertise.

Are there ways to institutionalize a role for law professors in commenting on financial regulations? Would it make sense to create a “college” of experts on financial regulation who can comment on proposed rules without being paid by industry? Would something like ALI work? The ABA has a number of financial reform committees, but they are often made up largely of lawyers whose clients have big stakes in the regulatory outcomes. Should we carve out a role for comments from regulators from other countries?

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• Michael Barr, currently at Treasury, usually at Michigan, notes that Congress gave the department the authority to enter into Basel III.
• Peter Henning foresees a cultural change in the SEC.  You can see that that old weird incentive for turf maximizing regulators - do a bad job, get a budget increase - is hard at work, as he notes.  One might think of the agency as today's southern prison warden.
• Mike Koehler is very worried about a little foreign corrupt practices reporting requirement for publicly traded extraction firms.

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In every Congressional session in recent memory, legislation has been proposed to somehow curb executive compensation.  Two narratives are commonly used:  (1) executives should not receive pay without performance and (2) the difference between employee compensation and executive compensation should not be as large as it is.  Both of these arguments are hard to counter.  It's hard to argue that anyone should be paid more than they deserve, and falling back on traditional concepts of enforcing arms-length bargains just isn't that catchy.  And who wants to argue for income disparity?  That doesn't win you a lot of friends, either.  However, most of these proposals just languished until the 2008 Financial Crisis, when bill writers dusted off old executive compensation legislation and inserted the words "systematic risk" a few times.  Now we have a third narrative:  incentive-based compensation created a system that rewarded excessive risk-taking.  This isn't just bad for the individual companies, so we can't just leave it to them to rework their bonus structures.  This type of excessive risk-taking is bad for the system, so we must regulate it.

So, everyone's favorite part of the executive compensation protest finds a home in the Dodd-Frank Bill, in Subtitle E of Title IX -- Investor Protections and Improvements to the Regulation of Securities.

Say on Pay

First, under Section 951, shareholders must receive information and get the right to vote on executive compensation at least once every three years in a separate resolution.  (However, once every six years, shareholders have the right to vote on whether this compensation vote should take place more frequently.)  Of course, the big catch is that this vote is nonbinding.  So, the corporation is going to spend a lot of shareholder money hiring lots of compensation experts and legal experts to create these executive compensation packages and disclose them in proxy materials, just so the same shareholders can vote on the packages, a vote which has only signalling value.

Pay Without Performance

Then, under Section 953, publicly-held corporations must also disclose every year to shareholders how executive pay is connected to executive performance.  Charts and graphs may be used.

Intra-Firm Income Disparity

Also, under Section 953, this annual disclosure must include (1) the median of all "total compensation" of all employees except the CEO; (2) the CEO's total compensation and (3) the ratio of (1) to (2).  (As an aside, I'm not sure if taking out the CEO's compensation in (1) is meaningful given the definition of "median" and the number of employees in most publicly-held corporations, but that's just an aside.)

Clawback

Our old friend Sarbanes-Oxley provided that in the event of an accounting restatement, that CEOs and CFOs would have to reimburse the company for any bonus or other incentive-based compensation (including stock options) earned during a 12-month period after the erroneous financial statements were certified.  Dodds-Frank expands this to any executive officer returning incentive-based compensation received up to three years before the date of the restatement.  However, this clawback is not an SEC enforcement mechanism; the clawback rule is required to be a policy of each company's compensation structure.

My problem with most regulation of executive compensation is that it is regulating where the streetlamp is shining.  We know who an executive officer is and who it isn't -- it's a discrete group.  But the great bulk of the risk-taking is done by nonexecutives.  The real players who have a lag in between their being compensated on projects and the fulfillment of those projects (investments, trades, etc.) are generally not executives.  The traders who were in line to get multi-million bonuses in 2008 and 2009 and who were lambasted in the press were not executives.  But, this is an easy bone to throw at the clawback contingency.

We Hate Speculators and Those Who Would Bet Against Us

Section 955 requires ocmpanies to disclose employees and directors who engage in hedging investments regarding company stock.  So, never mind when employees' retirement accounts are frozen and they can't sell company stock even when everything is going to heck in a handbasket.  They can't hedge, either.

Systematic Risk

Under Section 956, the "appropriate federal regulators" will promulgate new rules for "covered financial institutions" to disclose their inecentive-based compensation arrangements so that these appropriate federal regulators can determine whether their compensation arrangements for executives, employees and directors is "excessive" and whether they "could lead to material financial loss."  Because if a company can't see that all flags are pointing toward material financial loss, I'm pretty sure that appropriate federal regulators can.

And just before you thought that all these "Improvements to the Regulation of Securities" were mere disclosure items, nonbinding votes and window dressing, wait.  These appropriate federal regulators will also promulgate new rules for covered financial institutions that will prohibit these compensation arrangements that "encourage inappropriate risks."  Now, if we only had a good rule that told us when compensation was excessive and when a risk was inappropriate. 

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In the wake of Sarbanes-Oxley, Henry Butler and I wrote a book called the Sarbanes-Oxley Debacle. We closed on this hopeful note:

An understanding of [the Act’s] high costs and minimal benefits, and of the forces that produced this misguided legislation, may help to prevent a regulatory debacle in the future. We make specific recommendations for any future regulation of the capital markets that are suggested by the SOX experience, including optional provisions, periodic review and sunset provisions, and regulation whose scope is more carefully designed and focused. SOX should teach us to respond to fraud in a more measured way, with regulation that works with, rather than against, markets.

Unfortunately, the Dodd-Frank 2,315 page monstrosity taught me an important life lesson about optimism. “Measured” is not the word I would use to describe it. I recently reviewed some of the worst features:

• Corporate governance provisions, including shareholder voting on executive compensation, "clawbacks" on compensation paid to innocent executives, authorization for SEC proxy access rules, and restrictions on broker voting that will make shareholder elections more costly without doing anything to ensure that executives will catch the risks they missed last time around. 
• The hedge funds that did catch those risks and that largely avoided the meltdown will be subject to new registration and disclosure requirements. 
• The law imposes new fiduciary duties on securities sellers. The Supreme Court in Jones v. Harris recently punted on trying to fix a fiduciary duty provision Congress imposed on investment advisors 40 years ago (watch for my forthcoming article on Jones, which I plan to post soon). Now we can have another 40 years of litigation trying to figure out this new set of duties. 
• The bill gets praise for its “Volcker rule” restricting banks’ proprietary trading. Yet the law allows banks to risk their money by trading in what they call customer accounts. So now the trading just shifts to a setting in which it will exacerbate conflicts between customers and banks. 
• The law requires end-users of derivatives to post collateral – a little provision that the International Swaps and Derivatives Association famously estimated will cost the economy up to a trillion dollars will reducing the beneficial use of derivatives. At the same time it will do little to prevent another financial crisis.
• Last but certainly not least, the bill will certainly not end regulatory uncertainty in the markets. A Davis-Polk memo paints an exciting picture an exciting picture of the future under Dodd-Frank, in which it notes that “market participants will need to make strategic decisions in an environment of regulatory uncertainty” and that “regulators and market participants will be dealing with the bill’s consequences, both intended and unintended, for many years to come.” Among other things, the memo says to expect 243 rulemakings and 67 studies required by the law; persistent ambiguities “that will require consultation with the staffs of the various agencies involved;” and the need to adjust the regulation to changes in market behavior as well as to the technical fix bill promised by Chairman Frank.

But all is not bad. Dodd-Frank did do one good thing by fixing one of the worst hangovers from the SOX debacle: it exempted small-cap companies from SOX’s heinous internal controls attestation requirement. Maybe the next financial law, after the next financial meltdown, will fix some of Dodd-Frank. I am no longer optimistic enough to expect more.

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Back in March, when the Senate Banking Committee approved an early version of the financial reform bill that ultimately became Dodd-Frank, the angel investor community was in a tizzy. That bill would have increased the thresholds for "accredited investors" from the current levels ($1 million in net worth or annual income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years), and would have required the SEC to adjust the new amounts "not less frequently than once every 5 years, to reflect the percentage increase in the cost of living." 

The current numbers were adopted in 1982. Adjusting those numbers for inflation could have changed the investment for angel investors dramatically. Doug Cornelius figured those levels could increase to $459,000 for singles and $688,000 for married investors, with the net worth requirement rising to $2.29 million. The Angel Capital Association sprang into action, claiming that this change would result in a reduction of accredited investors by as much as 77%. 

In response to the ACA, the National Venture Capital Association, and others, the bill was amended. Dodd-Frank has raised the net worth threshold for "accredited investors" (by excluding the primary residence from calculation of net worth) but prevents further increases for at least the next four years: "during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person." Also under Dodd-Frank, the SEC is charged with adjusting the numbers within four years after 2014. The ACA is pleased.

So did Congress do the right thing in holding the line on accredited investor standards? 

The argument against changing the thresholds is straightforward: "At a time when many accredited investors have lost more than 20 percent of their net worth in 2008 and innovative start-ups are having an increasingly difficult raising equity capital, decreasing the potential pool of angel investors is counter-productive to supporting the very companies that will create new high-paying jobs."

I don't claim to know the right levels for the thresholds, but if we think that disclosure regulations provide valuable protections to some investors, those levels should be established at least in part by reference to the need for investor protection, not merely the need for startup funding. How does the fact that "many accredited investors have lost more than 20 percent of their net worth in 2008" argue in favor of maintaining the status quo? Speaking with angel investors, I sense that many (most?) of them place almost no value on disclosure regulations. While I am more than happy to play the skeptic on the value of mandatory disclosure, perhaps we ought to find out which investors, if any, benefit from the disclosure system before we set these thresholds.

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I'll take a stab at Erik's question as to what's missing from this mammoth bill.  Like Erik, I think the biggest problem area is shadow banking and leverage.  He's right that a part of what's missing is more guidance as to how to measure leverage--although I personally have no idea how to do that in a way that doesn't invite rampant evasion.  But at least as big a problem is who to regulate.  Despite all the focus on "too big to fail," I think that this crisis, like that of the 1930s, illustrates that systemic collapse can occur when many medium-size institutions in linked markets follow similar investment strategies that all go wrong at once, leading to forced attempts to unwind their positions and something that closely resembled a bank run.  It seems to me that is what happened in areas like the repo market and the commercial paper market.  Insofar as the Act leaves the players in the shadow banking system unregulated, it may make matters even worse, as the many new regulations of the banking system "in the light" push more money and talent into the shadows.

Dodd-Frank has at least two parts that start to attack the problem, but they have complementary holes. Title I's regulation of nonbank financial companies that pose a risk to the financial stability of the U.S. will extend quite significant regulation, including regulation of leverage, to a new set of companies.  Much depends upon how broadly the Financial Stability Oversight Council interprets that power, but I fear that it will extend this regulation to only a few very large companies, leaving many smaller players untouched.  Conversely, the new rules for hedge fund and private equity advisers will cover many players within the shadow banking system and give the regulators important new information.  However, that section of the Act (Title IV) extends very little new substantive regulation, and thus does not limit the leverage those companies can undertake.

I also agree with Erik that it's important to focus on pushing regulators to respond to developments in the market.  New rules will lead to new strategies by actors in the markets, and changing circumstances will lead to further innovations.  Financial regulators must always work hard just to play catch up.  But, I'm ever-so-slightly more optimistic than Erik that Dodd-Frank has some provisions that may help.

First, the Financial Stability Oversight Council, which Erik dislikes, seems to me to have some potential.  It brings together the leading regulators who collectively have much information on financial markets, and it directs them to meet at least quarterly to identify risks to financial stabiltiy, including identifying gaps in regulation.  They must annually report to Congress on what they have found.  Now, you can lead a horse to water but you can't make it drink.  When things are booming and a laissez-faire mood reigns supreme, those meetings and reports may well do no good.  But it at least forces regulators and Congress to regularly think about these issues, and provides a forum for any regulator or member of Congress who is not asleep at the switch to raise concerns. 

Second, there's an interesting new body, the Office of Financial Research (Title I, Subtitle B).  Within this is a Research and Analysis Center.  These are charged with monitoring risk and regulation and reporting annually to Congress, as well as to the Council.  With an ambitious and energetic Director and staff, that Office could take leadership in asking probing questions about what emerging risks loom for the financial system.  Indeed, if the Director wants to make a name for herself, that seems the route to go--which is just the kind of incentive we want someone within the agencies to have.

I don't mean to be Pollyannish about this.  The Act almost certainly doesn't anticipate what's likely to go really wrong next time, and the regulators probably won't either.  Indeed, that's pretty well true by definition--if they did anticipate it, after all, they would presumably act to stop it.  But I do think there's some hope that under this structure the regulators will be pushed to identify at least some important risks and work to stop them, so that maybe the next big crisis will come in 25 or 30 years rather than 5 or 10 years.  If we're lucky.

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So, in case you're waking up today thinking, I'm going to do a quick read of the Restoring American Financial Stability Act of 2010, a word to the wise.  First, it's really long.  In PDF, on my computer, it's over 800 pages long.  Here's the CRS summary, which printed out to around 50 pages on my computer, but it's six months old and the numbering has changed.  If you are just wondering what's in the Act, here are the high points, and I've starred and bolded sections that I'm hoping to talk about later in the forum.

Title I

Subtitle A, Section 111, et seq. -- establishes Financial Stability Oversight Council; grants powers to the FDIC to do certain things to "prevent systemic financial instability during times of severe economic distress" and broadens its powers.  Also anticipates increased regulation of financial holding companies by the Federal Reserve; established the Office of Financial Research.

Subtitle C, Section 161, et seq. -- redefines "bank holding company"; increases reporting requirements of bank holding companies and increases capitalization requirements.

Title II

Section 201 -- provides for "orderly liquidation" of certain financial companies.

Title III

Subtitle A, Section 311 -- Enhancing Financial Institution Safety and Soundness Act of 2010; transfers functions of the OTS to Board of Governors and OCC.

Subtitle C, Section 331 -- improvements to the Federal Deposit Insurance Fund

Title IV

Section 401 -- requires registration of private fund investment advisers (The Prevent Another Bernard Madoff Act , Part I).

Title V

Subtitle A, Section 501 -- creates Office of National Insurance

Title VII -- Wall Street Transparency and Accountability

**Subtitle A, Section 711 et seq. -- addresses the regulation of derivatives, particularly swaps.

Title IX -- Investor Protections and Improvements to the Regulation of Securities

Subitle A, Section 911  -- Investor Protection Act of 2009; establishes Investor Advisory Committee.

**Subtitle B, Section 929H -- SIPC Reforms (The Prevent Another Bernard Madoff Act, Part II).

**Subtitle B, Section 929L et seq. -- enhanced application of antifraud provisions in securities acts.

Subtitle B, Section 929X -- short sale reforms

Subtitle C, Section 931 et seq. -- Improvements to the Regulation of Credit Rating Agencies

**Subtitle D, Section 941 et seq. -- Improvements to the Asset-Backed Securitization Process; amends both the Securities Act of 1933 and the Exchange Act of 1934 to add requirements for the issuance of asset-backed securities, particularly mortgage-backed securities.

**Subtitle E, Section 951 et seq. -- Accountability and Executive Compensation; requires nonbinding "say on pay" shareholder vote and other reforms.

Subtitle F, Section 961 et seq. -- Improvements to the Management of the SEC

Subtitle G, Section 971 -- proxy access

Title X -- Burea of Consumer Financial Protection

Subtitle A, Section 1011 et seq. -- establishes the Bureau of Consumer Financial Protection to prohibit unfair, deceptive, or abusive acts or practices.

Title XI -- Federal Reserve System Provisions

Section 1101, et seq. -- granting addition powers in emergencies.

Title XIV -- Mortgage Reform and Anti-Predatory Lending Act

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Here are a few big-picture questions, I’d like to ask the Masters in the Forum

• What’s the most sensible part of the legislation?
• What’s the worst part? What is the most useless or counterproductive piece of the mammoth bill?
• What’s missing?
• What’s the most likely to end up being litigated or struck down by the courts? It may take a while (the PCAOB litigation wound its way to the Supreme Court for years while another crisis percolated), but which part of Dodd-Frank is most likely to end up before the Supremes? Will that piece be struck down?

Let me take a stab at the third question. There is a tendency in financial reform to fight the last war and this time is no different. But how likely is it that the next crisis will involve subprime mortgages and credit derivatives? Instead of building Maginot lines in our financial legislation, we should be thinking about the next crisis.

Leverage and the parallels to other crises

If one looks, though, with the right level of abstraction, this crisis does have deep parallels to other crises. Taking a comparative perspective, Europe would have suffered its own financial crisis even if no German bank or Norwegian village had purchased mortgage-backed securities. Indeed, Europe suffered a real estate bubble that stretched from the Baltic to the Balkans and many places to the west too. We can also take a historical perspective and draw parallels to many asset price bubbles over 300 years.

The factors that tie these global and historical episodes to our own is not only a wave of inexperienced first-time investors, but, moreover, a marked increase in credit and leverage – on the part of both households and financial institutions. It’s this increase in credit and leverage that explains the most pernicious effects of subprime mortgages, mortgage-backed securities and cdos. I argued in an earlier post that this was also the most troublesome aspect of credit derivatives – the ability to increase credit, leverage, and the effective money supply in the entire financial system.

Are lawyers and financial reform laws even necessary?

A number of economists have done critical work hitting on the importance of leverage in the current crisis, including:

• constructing a model of a leverage cycle (see Geanakoplos),
• providing empirical evidence that financial institutions take on leverage procyclically (that is increasing leverage as markets boom and decreasing leverage as markets contract; see Adrian and Shin); and
• describing how “shadow banking” – the web of securitization and credit derivatives that connected mortgage borrowers, assorted financial institutions, and capital markets – provided an alternative credit channel and a means to produce leverage that bypassed the more regulated borrower-bank-depositor chain.

One reading of this economic literature might be that laws and even financial reform is more of a sideshow to getting macroeconomic policy right. This would be a more sophisticated corollary to the story that goes: “the real culprit in the financial crisis was Alan Greenspan keeping interest rates too low for too long.”   In this reading, what the Federal Reserve really needs to do is get better information on system wide leverage (perhaps by a broader gauge of the money supply) and manage the money supply and cap that leverage accordingly.

There are a number of problems with this type of macro approach which would leave the legal/regulatory picture in more soft-focus, including that:

• Monetary policy remains a blunt and inexact tool. Faulting Greenspan’s monetary policy doesn’t address the fact that central bankers face some pretty dicey choices with using this tool. Regulations can have a huge impact on leverage and the supply of credit.
• Financial regulations impact system-wide credit and leverage.  Changes to regulations like bank capital and reserve requirements and regulations that lose effectiveness can have consequences – often huge and unintended -- of increasing system wide credit and leverage.
• Figuring out how to cap leverage is easier said than done. As David noted in an earlier post, the Basel Committee is looking at proposals for harder leverage caps to complement traditional capital requirements.
• Rules will inevitably be gamed. In fact the shadow banking system – from subprime mortgages to securitization to credit derivatives – is largely a creature of regulatory arbitrage, including the arbitrage of accounting rules. I

In essence, I am saying that, even in a macroeconomic approach, rules matter, figuring out how rules can be gamed matters, figuring out the incentives to game rules matters, and lawyers matter.

What’s missing from Dodd-Frank?   A Donut with Two Big Holes.

All of this is a very circular way of addressing my original question of what’s missing from Dodd-Frank. The bill does address leverage in a number of ways. For example, there are provisions requiring large banks to increase capital (although this strikes me as the wrong part of the cycle to do this). Requiring OTC derivatives to move to changes might clamp down on the leverage created by credit derivatives – but only obliquely (that wasn’t the real purpose of the clearing proposal) and weakly (anyone want to bet just how many contracts will move to a clearinghouse as a result of the bill?).

But the role of the shadow banking system in the crisis points to two bigger issues that are not adequately addressed in the bill:

Accounting: to regulate leverage and credit requires that we have an effective metrics for measuring leverage. That means looking at balance sheets, which means having a good command of accounting rules. But again, shadow banking and securitization reflected a gamesmanship of accounting rules with echoes to some of the off-balance sheet shenanigans of the Enron era. Dodd-Frank doesn’t begin to address the off-balance sheet problem adequately. Do you trust FASB to come up with the right answer? Unfortunately, most of the accounting debate with respect to the crisis focuses only on the role of mark-to-market.  (Maybe it is time to turn on the Bat-Signal and get Larry Cunningham to come to the rescue). 

The Incentives of Regulators: To stop fighting the last war and start preparing for the next one, we need to start thinking about the capacities and incentives of financial regulators to deal with financial innovation and regulatory arbitrage. Wall Street will continue to invent new products that shift risk, extend credit, and generate leverage. I’ve said this before: the great unsolved problem of financial reform is not “what new duties and powers do regulators need?” but “how do we get regulators to do the jobs they already have?”

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Insurance, often to the consternation of the largest firms, is regulated by the states, with a consumer protection and litigation ethos (different from the disclose, disclose ethos of securities regulation and the safe and sound ethos of banking regulation, if you want to be broad brush about it).  The states often tout the stability of the insurance industry as a reason not to change things.  In this view, it is not New York that was to blame for the collapse of AIG - its ordinary insurance operations were quite stable - but the regulatory gap in which its financial products subsidiary operated, which was basically making bets about the creditworthiness of corporate debt.

Dodd-Frank does a wee bit of federalization of insurance, and it is worth being clear on exactly how much.  It creates a Federal Insurance Office, sites it in Treasury, and puts its director on the council of financial regulators that are supposed to coordinate regulatory policy in the future, albeit in a nonvoting capacity.  The office would make recommendations about who in the insurance industry warrants labeling as "systemically significant."  And it must otherwise monitor the industry, and advise the secretary on international and domestic insurance issues (the international issues means that the FIO will be participating, presumably, in the efforts to harmonize international insurance rules; Congress also gave Treasury the power to enter into international insurance agreements in the future).  The office has subpoena powers to assist in this information gathering, has the power to preempt state insurance rules that violate international agreements or discriminate against foreign insurers.

On the other hand, the innovation isn't earth shattering in other ways.  The FIO director would be a career civil servant, rather than a political appointee.  The office is not permitted to examine health, long term care, and crop insurance.  There's an explicit provision in Dodd-Frank preserving the regulatory authority of states over their insurers.

So what appears to be going on here is a sense that insurance regulators are protecting local businesses, in addition to a realization that insurance companies can be systemically significant.  The FIO is designed to keep the government apprised of the latter possibility, while international competition and coordination is being encouraged with a view to addressing the former problem.  It is interesting because, in my view, it represents a hope that the idiosyncracies of state regulation of insurance will fade away with globalization, coordination, and the light touch of a brand new federal regulator with some powers over an old industry.

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