Dodd Offers Improvement, But Not Finality

I have to say, Dodd’s proposed financial reform bill is an improvement over what was previously offered in both House and Senate. In particular, I like the attempt at clearly distinguishing between solvency and liquidity problems, as well as the publicity requirements surrounding emergency assistance facilities.

Nonetheless, there are still gaping holes in the proposed legislation that, if left unfilled, will create new perverse incentives among both financial institutions and their regulators. In this week’s commentary, I am choosing to focus on a few seemingly innocuous provisions in Dodd’s financial reform bill that can have significant ramifications for the industry.

Financial Utility

Section 804. Designation of Systemic Importance, authorizes the Financial Stability Oversight Council to designate financial market utilities or payment, clearing, or settlement activities as systemically important, and establishes procedures and criteria for making and rescinding such a designation. Criteria for designation and rescission of designation include the aggregate monetary value of transactions processed and the effect that a failure of a financial market utility or payment, clearing, or settlement activity would have on counterparties and the financial system.

Really though, specifically, what is a “financial market utility”? The proposed language says a financial utility is something that poses systemic risk, which is caused by financial market utilities. Hence, we are still going around in definitional circles, struggling to build legislation around an amorphous concept that – we can admit now or later – has not firm definition.

Worse yet, over the history of commercial banking we have struggled repeatedly with the much simpler question of “what is a bank?” The simple, seemingly firm, definition is an institution that takes deposits and makes loans. But the Competitive Equality in Banking Act of 1986 shows that such a definition was inadequate (and the size restrictions that Act imposed gave rise to securitization). We continued to struggle with the definition in the recent crisis. New undefined terms won’t help.

Material Loss Thresholds

Section 987 raises the “material loss” threshold that triggers a review of a failed federally regulated bank by Inspector Generals of the regulator from the current $25,000,000 to $100,000,000 for the period between September 30, 2009 and December 31, 2010, then lowers it to $75,000,000 for the period between January 1, 2011 and December 31, 2011, and rests it at $50,000,000 for the period after January 1, 2012.

Anybody who doubts the importance of this provision should be reading the Inspector General Material Loss Reviews on recent bank failures. If you don’t have time for that, then pick up Gillian Garcia’s paper summarizing the findings. In short, regulatory failures continue to plague the industry, not at the level of the FDIC but at the level of the primary regulatory prior to handoff to the FDIC for problem bank resolution. That is the same problem we had in the Thrift Crisis. Decreasing the Material Loss Review threshold will prevent accurate diagnosis and hinder further attempts to constrain the problem.

FDIC Open Bank Assistance

While other sections on liquidity assistance specifically advocate propping up only solvent institutions, the FDIC lending section does not seem to contain such restrictions. Hence, the section smacks of open-bank assistance, which didn’t help in the Thrift Crisis and won’t help in future crises either. In fact, FDIC itself was supposed to have been prohibited from providing open-bank assistance by FDICIA’s least cost resolution provisions. More fundamentally, lending to weak banks has never helped them survive, whether that was in the Great Depression, Japan, or recently. Insolvency is a problem of having debt greater than assets: more debt won’t help.

Appointing the President of the Federal Reserve Bank of New York

Section 1157.  Changes to Federal Reserve Governance amends The Federal Reserve Act to state that the Federal Reserve Bank of New York president, who is currently appointed by the district board of directors, will be appointed by the President, by and with the advice and consent of the Senate.

The provision for having the President of the Federal Reserve Bank of New York appointed by the President and confirmed by senate is ironic in the history of Congress in general, and the Federal Reserve specifically. Recall, originally the heads of the Federal Reserve Banks were called Governors and the members of the Board, Presidents. Foreign central bank convention was to call the head of the system a Governor, so they directed their attention to the Governor of the Federal Reserve Bank of New York. The Board struggled to realign perception and then reign in reality by changing the titles and then commanding Board preeminence over Banks in a struggle that lasted much of the 1930s. So are we turning back to the pre-1930s Federal Reserve System in this move? Do we really want to move the seat of power closer to New York? Historically, that’s why we moved the nation’s capitol to Washington.

Moreover, the balance of power with Washington is why we allowed the Federal Reserve Banks to be (partially) controlled by bankers. Remember, the Federal Reserve System is supposed to be a public-PRIVATE partnership, in the style of early bank clearinghouses. Tilting that balance toward Washington as advanced in the present language serves no obvious purpose.