Republicans Scuttle Fed Nominee: More of the same electoral politics that put workers last

There are three vacancies on the Federal Reserve Board of Governors.  That’s a big deal – maybe the biggest deal for economic recovery you’ve heard almost nothing about in the mainstream press.

The economy has been growing for most of the past year, but data from the second quarter of 2010 are showing new signs of a slowdown. Unemployment hasn’t come down, and may be showing signs of inching up again. All this is great news for Republicans heading into the fall elections. Their biggest fear is that voters might see signs of recovery and jobs growth, and scuttle Republican chances for big gains in November.

 But how do Fed nominees play into the Republican equation for electoral victory?

 The Fed is the only body that can now take serious action to boost the economy.  Thanks to Republican obstructionism, and misplaced hysteria over the short-term budget deficit (the solution is putting people back to work, paying taxes and growing the economy), nothing more will come out of Congress this year. So what better for Republicans than to ensure continued gridlock at the Fed, guaranteeing continued high unemployment at least until after the November elections?

Obama has nominated three highly qualified candidates to fill vacancies on the Fed Board of Governors: Janet Yellen, president of the Federal Reserve Bank of San Francisco has been nominated as vice chair; Sarah Raskin is currently the Maryland commissioner of financial regulation; and Peter Diamond is a Massachusetts Institute of Technology economics professor (an former professor of Fed Chairman Ben S. Bernanke).  All three candidates were voted out of the Senate Banking Committee last week, clearing the way for action by the full Senate.

Diamond is an expert on economic risk. This background would be central to Fed efforts to develop policies and make decisions to avoid future financial crises. He is an expert on Social Security, pensions, and taxation issues. Raskin, a former counsel to the Senate Banking Committee would increase the Fed’s expertise on financial regulation, an area that clearly was lacking under “Bubbles” Greenspan’s leadership.  Raskin’s expertise includes consumer issues, which will be important as the Fed implements new regulations approved under financial reform.  Yellin, with a long history on the Fed, has said that regulators were “slow” to crack down on risky banking practices that led to the 2008 financial crisis. She and Raskin agree that the Fed needs to pay more attention to curbing speculative excesses in the economy going forward. Yellin says the Fed must place a high priority on job creation in crafting monetary policy.

Yellin and Diamond are both considered “doves” on monetary policy.  As such, they are currently more concerned with high unemployment than with rising inflation.  Rightly so, given that deflation is now a much bigger threat than inflation.  Deflation means falling wages, prices, profits, investment, consumption, and production.  The economic consequences are devastating, and it is a cycle that is much more difficult to reverse than inflation.

A number of conditions pointing to deflation are currently in play, with excess capacity in the form of unemployment and underemployment; slack consumer demand; and underutilized capital resources as companies and banks hoard cash.  Producer prices and consumer prices are both barely in positive territory, which is a concern. Over the past year, a large proportion of the components of the CPI have in fact been negative, particularly related to consumer discretionary spending. Core inflation could be well under 1% for 2010, which is in dangerous territory.  With a still-extant debt overhang, especially mortgage debt, deflation would be devastating to ordinary Americans.

And the deflation dynamic could be further complicated if the dollar appreciates relative to other currencies (especially the euro, where sovereign debt is a concern in some countries); if oil prices decline; if housing prices enter a second dip. 

Yet, like old generals still fighting Communists, inflation hawks continue to dominate the policy debate. 

Modest inflation, perhaps up to 3.5 to 4.0%, would actually be a big plus for ordinary Americans laboring under mortgage and credit card debt. Wouldn’t you rather pay your 5% mortgage back with cheaper dollars?  A lower valued dollar and mild inflation would unleash additional discretionary spending and make U.S. exports more competitive.  That would get the economy moving in the right direction.

All this means the Fed needs precisely the expertise of the nominees that President Obama has ordered up.  Filling these vacancies now is crucial as the Fed steers the economic recovery, which remains extremely fragile and vulnerable to shocks.

So what happened this week in the Senate? Peter Diamond’s nomination was sent back to the White House for “reconsideration,” because of objections from Republican lawmakers. The action was taken without debate before the Senate left for recess. The action was likely the result of Alabama Sen. Richard Shelby’s comment that Diamond “may not be qualified to make decisions on monetary policy.”  Republican hostility emerged during committee hearings, when Diamond rightly said he is currently more concerned about deflation than about inflation.

Raskin and Yellin’s nominations are still alive, but those, too could be scuttled when the Senate reconvenes in September.

With the Federal Open Market Committee scheduled to meet in a few days, it is unclear when there will be a full complement of governors. There have been two vacancies going back to January 2009, and August 2008, leaving the board short-staffed during a critical period.

It is not clear that Obama could appoint Diamond while the Senate is in recess, but it is certain he will not do so, as it would create tremendous ill-will, even among some Blue Dog Democrats. Hopefully, he will at least stand firm, and resubmit the nomination for Senate consideration. And he ought to make this an election issue.  Republicans know that the longer the Fed remains in its current log jam, the longer the economy remains flat and unable to reduce unemployment.  Republicans are once again playing politics at the expense of ordinary working Americans. Obama needs to loudly call Republicans out on this…yet another act of political and economic sabotage by the party of “No.”

Obama’s Foreign Policy: What approach now?

Obama’s Foreign Policy: What approach now?

By Paul Crist

Since taking office, President Barack Obama has had to grapple with an endless list of thorny issues, but few areas of policy are more of a minefield than foreign policy.  In the Middle East, Asia, Latin America, and elsewhere, he faces challenges that defy solutions.  Two hundred years of history provide him with role models and approaches that should guide him through the global minefield he faces.  But who should he emulate to ensure a successful foreign policy?  What foreign policy philosophy most closely resembles his basic instinct?  Which constituencies will support, and which will oppose, the policy choices he makes?  And what are the domestic political implications of the foreign policy choices he makes?

American foreign policy through the centuries has been characterized by four fundamentally different philosophies that can be traced to four great historical figures: Alexander Hamilton, Thomas Jefferson, Andrew Jackson, and Woodrow Wilson. 

Hamilton favored a realist policy that included a strong national government, powerful military, and the promotion of American business and economic interests through strength and engagement.  It was Hamiltonian realism that kept George H. W. Bush from pursuing Saddam Hussein in the first Gulf War.  Bush Sr. was tempted by the goal of toppling the Iraqi regime, but his strong realist instinct prevailed, understanding as he did that the political and human costs were too high.  Mocked for his frequent use of the term “prudence,” Bush was, in fact expressing a Hamiltonian, clear-eyed calculation of risks and benefits, balancing ambition with feasibility.

Jefferson sought to limit American interventionism and global commitments, and where possible, minimize the need for an extensive national security apparatus.  Jeffersonians believe that America can best spread democracy by example, pursuing a moderate, if not isolationist, foreign policy.  Jeffersonians see American exceptionalism as being rooted in uniquely American values and experience, and thus it is not possible, nor is it America’s job, to see that the rest of the world follows the American path to democracy.  Jeffersonians believe that major overseas commitments undermine U.S. democracy, sapping budgets of resources for domestic needs, while often associating America with corrupt and oppressive regimes in cynical alliances.  A large military-industrial complex, naturally pro-engagement and seeing threats around every corner, is a threat to civil liberties, and should be contained.  Jimmy Carter came from this philosophical pillar of U.S. foreign policy, and like him, Obama comes from the Jeffersonian traditions of the Democratic Party. 

Wilson was an idealist, in agreement with Hamiltonians on the need for an activist foreign policy, but with the goals of promoting democracy, seeking justice, and protecting human rights.  Wilsonians doubt that international stability and order are possible without democracy, protection of rights, and justice.  American idealism did not originate with Wilson, of course.  In the early days of the Republic, when America wielded little power on a world stage dominated by imperial England, idealism helped forge an American sense of justice and virtuosity that European colonial powers surely lacked.  Even the “manifest destiny” of creating a nation that spread across the continent to the Pacific Ocean was infused with a (wrongly placed) sense of idealism and virtue, aiming to “tame” the wilderness and “civilize” and “Christianize” the “primitive” native peoples.  Wilson’s call for American entry into World War I, to “make the world safe for democracy,” was merely the high point of American idealism prior to achieving great-power status.  What is surprising is that American idealism continued as the U.S. picked up the mantle of a great power.  Idealism and great-power realist politics can make awkward bedfellows.

Jacksonians are populists, suspicious of government and foreign entanglements, distrustful of Hamiltonian business connections, Jeffersonian weakness (or cowardice), and Wilsonian do-gooders.  Jackson’s Presidency represented a major departure in American politics, the rise of the common man.  Jacksonians are not deep thinkers, so are susceptible to populist leaders regardless of the internal inconsistencies in their values, claims, or policy proposals.  Jacksonians are the Fox News viewers of today.  While suspicious of foreigners and international entanglements, they also hate to lose, especially to terrorists engaging in “dishonorable” warfare.  When America is attacked, they demand revenge and will not likely support a U.S. pullout from countries providing safe haven for evil terrorists.

Barack Obama waged his Presidential campaign largely on anti-war Jeffersonian principles and a focus on domestic issues such as health care and education.  That approach opened him up to accusations of weakness from Hamiltonians, cowardice from Jacksonians, and moral spinelessness from Wilsonians.  His promise to renew efforts to hunt down Osama bin Laden in Afghanistan garnered him little support among Jacksonians, who doubted his commitment.

As President, Obama’s approach must be influenced by all four approaches to foreign policy.  But it is seldom clear just what the right mix should be, and that opens him up to criticism from all sides.  In particular, Obama must guard against calls from the Jeffersonian wing of the Democratic Party that makes up his base.  Perceptions of Jeffersonian foreign policy cowardice fatally damaged Carter’s Presidency. 

George W. Bush’s failure to realistically assess the risks, costs and benefits of waging wars in Afghanistan and Iraq, and subsequent shift of focus to nation building, cost him the support of Hamiltonian realists, and won few supporters among Wilsonian idealists who never trusted his motives.

Jacksonians, influenced by the legacy of conflict with Native Americans who didn’t fight by European conceptions of “fair war-making,” and angered when America was attacked on 9/11, demanded that terrorists be hunted down and killed without mercy.  When no weapons of mass destruction were to be found; no connection could be established between Saddam Hussein and al Qaeda; and as the focus shifted away from hunting down Osama bin Laden, Bush argued that the goal was to establish stable democracy and ensure human rights for Iraqis and Afghans. That shift cost him the support of the Jacksonian wing of the Republican Party, who have no interest in idealistic meddling abroad.

Wilsonians opposed the war in Iraq from the beginning, so were never fully on board with Bush foreign policy.  The late shift to nation building goals in both Iraq and Afghanistan, rightly or wrongly, struck them as disingenuous and opportunistic rather than as a reflection of deeply held idealism.  Yet, if Bush honestly believed that democracy and human rights could be built at the barrel of a gun, he may have been our most idealistic President ever, firmly in the Wilsonian mold.

Of course, Jeffersonians argued from the beginning that the Middle East wars were costly follies, doomed to make us less safe rather than more.   

Bush’s failure to develop and maintain support from constituencies supportive of these four pillars of American foreign policy opened him up to vitriolic criticism from all sides, and ultimately helped to open the political space that allowed Barack Obama to become President.

So how can Barack Obama avoid the pitfalls that Bush failed to circumvent?  It won’t be easy.

On Iraq, he ran on a Jeffersonian platform that called for bringing the troops home.  Those folks are his base.  That platform certainly didn’t enamor him to Jacksonians, who accused him of humiliating America with a “cut and run” strategy (he’d never have gotten those votes anyway, for other reasons).  Hamiltonians saw withdrawal as a threat to American economic interests, given that Iraq sits on billions of barrels of oil.  Wilsonians, already disillusioned at the prospects for democracy and open society in Iraq, were at least encouraged that Obama promised an orderly withdrawal, and transition to Iraqi control including nominally democratic elections.

Obama did throw a bone to the Jacksonians, and quite a few others, who felt that Bush had been distracted from the goal of getting bin Laden.  He promising to refocus on Afghanistan, the search for bin Laden, and to an extent, revenge for 9/11.  That promise pleased a lot of Hamiltonians, since defense spending was certain to keep important constituencies’ profits rolling in. 

Significantly, during the campaign he said almost nothing about Wilsonian nation building in Afghanistan, which is where much of the focus of his policy has been since taking office.  But, particularly after the flawed elections in 2009 and evidence of massive corruption within the Karzai government being widely reported in the U.S. media, even Wilsonian democrats are questioning the mission.  But, Obama has no good alternatives in this hotspot.

On a host of other regional issues, Obama has pursued a generally Jeffersonian approach to foreign policy.  Uncritical support for Israel has been toned down, helping to reduce anti-American hostility in the region.  He cancelled plans to deploy an anti-ballistic missile system in Poland and the Czech Republic, reducing the risk of conflict with Russia. In Latin America, he has taken steps to normalize relations with Cuba; avoided serious conflict with Venezuela and its leftist regional allies; and largely took a hands-off approach to the coup in Honduras (which infuriated idealistic Wilsonians).

It appears that outside of the Middle East quagmires he was handed in January 2009, Obama seeks an orderly world characterized by regional balance-of-power arrangements, shared burdens, and reduced global reliance on American military power in true Jeffersonian fashion.  His vision is attractive and ambitious, and if successful, could reduce the level of international tension while limiting unsustainable American commitments on the international stage. 

A Jeffersonian foreign policy of limited engagement, however, is fraught with challenges.  Unlike the 19^th century, when American could rely on and reap the benefits of British power to maintain global order, today there is no other great power ready and able to step into the void created by an American retreat from its role as international policeman.  Franklin Roosevelt’s first two terms were characterized by refusal to confront Germany and Japanese aggression, and the result was a catastrophic war, that ultimately, America could not avoid.  Events leading up to World War II showed the weakness in the Jeffersonian philosophy as British power waned.  Jeffersonians since have had to temper their more extreme isolationist impulses in the postwar era, as American commitments expanded dramatically.  But while Jeffersonians instincts are to limit commitments, it is not so clear where American should cut in the 21^st century.

The Democratic Party has a strong Wilsonian tradition, in addition to the Jeffersonian one, and Obama must pay attention to this constituency.  They ask, “If American should use its power and resources to overcome injustice and poverty at home, should it not seek the same for people everywhere?”  Wilsonians see America’s mission as moving the world toward the goal of universal rights, justice, and democracy.  Wilsonian foreign policy is value-driven and morally infused.  And like idealists Martin Luther King Jr., Abraham Lincoln, Jimmy Carter, and Eleanor Roosevelt, Barack Obama is strongly influenced by the Democratic idealist impulse.  Wilsonian Democrats are disappointed by Obama’s support for corrupt regimes like that in Afghanistan, and by military aid provided to Pakistan despite evidence that the government is a tepid and corrupt ally in the so-called war on terrorism.  The failure to close Guantanamo, continuation of Bush-era government secrecy, and refusal to investigate Bush administration abuses has angered Democratic idealists.  The choices Obama has already made, compromising both his Jeffersonian and Wilsonian impulses (and constituencies), have surely been difficult ones, and he is just over a year into his Presidency.  More unpleasant and unpopular choices are to come.

Obama has run afoul of believers in all the schools of foreign policy thought, almost at every turn.  The truculent partisanship that now grips Washington and the media has resulted, and will continue to engender, virulent criticism from those who seem more interested in crippling his presidency than in protecting national interests with sound foreign policies.  Sharp criticism, some of it menacing from the right, is also coming from some on the left.  Many in his base are disillusioned by the contrast between Obama the campaigner and Obama the President.

With just over a year in office, Wilsonians have accused him of moral cowardice for his refusal to meet with the Dalai Lama prior to his trip to Beijing.  Jacksonians, on the right, simply called it cowardice, happy to jump on any opportunity to berate the President.  Hamiltonians, who generally favor free trade, a strong dollar, and muscular projection of American power, are unhappy with the administration’s progress on trade deals, fiscal restraint, and his conciliatory approach to China in the face of what they see as predatory currency exchange policies.  His Jeffersonian base is unhappy with the failure to quickly extricate U.S. troops from Iraq, and increasingly, Afghanistan as well.   In the current political climate, Obama will need nerves of steel and a stiff upper lip to see him through.  If it was ever true that politics stops at the water’s edge, it certainly is not the case today.  While the current partisanship is troubling for domestic issues, it could have quite dangerous consequences in the foreign policy realm

Between the complicated situations he faces in the international arena, and partisan criticism on the domestic front, he could easily fall into a foreign policy morass that merely looks incoherent and inept, when what the world needs is clarity, a proactive approach (which is not “preemptive” …there’s a major difference), and firm leadership.

His widely criticized extended consideration on Afghanistan is illustrative of the minefield he faces.  Obama’s Jeffersonian instinct sees war as a serious matter that is not to be entered lightly, thus his deliberation and caution before announcing a decision.  Consequently, he satisfied no one by his handling of the issue.  Jeffersonians simply saw his eventual decision as a sellout; Hamiltonians felt that his lack of rapid action sent a message of American weakness; Wilsonians, who favor an emphasis on institution building, reconstruction assistance, and rights protection, were displeased at Obama’s willingness to adopt the military approach recommended by Gen. McChrystal; and Jacksonians saw cowardice and accused the President of “dithering.”

Abroad, Obama’s conciliatory approach may also be problematic.  Will Russia and Iran cooperate?  Or will they be emboldened by what may be interpreted as American weakness and lack of will?  Will outreach to the Muslim world result in better understanding? Or will it embolden the violent minority, undercutting his standing at home and abroad?  When Obama cannot deliver all of the concessions that Arabs want from Israel, will it result in even greater alienation and anger among Muslims?  Will other countries agree to cooperate and take up a larger role on the world stage, or will they fail to fulfill their obligations as stakeholders in the international system?  A lower American profile may make others less, rather than more, willing to step up and take responsibility, while emboldening extremist regimes and groups.

What seems clear is that a Jeffersonian approach of limiting American commitments abroad is not the course he can or should chart, given that retreat from the world stage would have unpredictable and potentially dangerous consequences for global stability, security, and order.  A foreign policy based on Hamiltonian projection of American power, along the lines of either Bush administration and seen by global friends and foes alike as arrogant and domineering, has arguably left America less secure rather than more.  Jacksonian revenge for terrorist acts no longer garners support in the international arena.

So, in the realpolitik of foreign policy, with regional problems all across the globe, how should Obama proceed?  It seems that no matter what approach he follows, the way forward is fraught with unpopular choices that will open him up to political attack from all sides.  As new powers rise and the international system transitions, Obama will have to rethink Americas place in the world and how to navigate often treacherous international currents.

Ultimately, he will have to blend three of the four pillars of American foreign policy.  Jeffersonian restraint will help to guard against “imperial overstretch.”  At times, a prudent application of Hamiltonian realism and projection of power will be required in order to maintain global order, which only the U.S. is in a position to do at this point in history.  But he must not abandon the Wilsonian idealism and dedication to democracy and justice that still lends America an aura of exceptionalism among many citizens around the globe.  His decisions will invariably be unpopular with someone, and sometimes, perhaps with almost everyone.

But as an overarching paradigm, America in the 21^st century must strive to create what Norwegian scholar Geir Lundestad has called an “empire by invitation.”  It is neither possible nor in our interests to compel subordination on the world stage today.  But we do possess the ability to provide incentives for willing participation on many fronts.  Economic incentives in the form of export credits; investment insurance or promotion; access to technology loans and technical assistance remain at America’s disposal.  In some cases, the lure of diplomatic recognition or participation in regional or international institutions, or the scheduling of summits between leaders can be attractive incentives.  Cultural and civil society incentives entail building people-to-people contacts; funding non-governmental organizations; facilitating the flow of remittances; and promoting tourism and student exchanges.  These options involve relationship building and non-coercive approaches that can convince states, strong or weak, to recognize and obey international norms of good behavior. 

While the international institutions that were born in the postwar era (United Nations, International Monetary Fund, World Bank, and what is now the World Trade Organization) may need reform and even radical re-thinking, they still provide a measure of law and reciprocity to international politics that America depends on now more than ever.  Those institutions, despite limitations, have supported unprecedented global economic expansion for three generations.  Newer challenges, such as adapting to climate change, may require new institutions, but these can only be built on the foundations of mutual trust that have been greatly enhanced by the institutions that have come before.

The U.S. policies of the past several years have deeply shaken trust in America and eroded confidence in the international institutions that are the foundation of multilateral life.  The full measure of damage done may not yet be fully comprehensible.  Obama must begin to nurture a renewed trust and confidence in the United States and in international institutions, or risk a markedly less secure world as new powers rise and old powers are in relative decline.  If he can see America through this complex period of global transition; make progress on restoring trust in American values, credibility, and dependability; and entice others to more fairly share the burdens of maintaining international order and stability, he will have accomplished something few great-power leaders in history have managed to accomplish.

Senate Financial Reform Bill: A Review of the Key Proposals

Senate Financial Reform Bill: A Review of the Key Proposals

By Paul Crist

March 28, 2010

The Financial Reform Bill introduced by Sen. Christopher Dodd (D-CT) appears to be, on the whole, a decent piece of legislation.  There are good arguments why various aspects may be weaker than they should be, but given the political landscape, Dodd has come up with a bill that ought to garner broad support from across the spectrum.  

It is widely recognized that the need for reform is urgent, and given the level of public anger toward bankers and the financial sector generally, fairly swift passage of this bill should be possible.  After all, are there 41 Senators willing to stand up and side with the bankers?  That would be very hard to explain to the constituents back home.

The bill is comprehensive in that it covers many issues, and detailed, with over 1,100 pages of regulatory reforms.  Assessing every issue in detail would be a daunting task (but somebody’s gotta do it).  But there are a range of specific areas that deserve consideration and comment.  The following issues will be briefly addressed here:

• The proposed Financial Stability Oversight Council (FSOC) and curbing industry influence over regulators;
• The proposed Consumer Financial Protection Agency (CFPA);
• Enhanced resolution authority and the “too-big-to-fail” problem;
• Proposed changes in the division of regulatory authority;
• Proposed regulation over trading of derivatives, asset-backed securities, and hedge funds;
• Proposals for financial brokers, investment advisors, and credit rating agencies.

 

Financial Stability Oversight Council and Curbing Industry Influence over Regulators

The Senate bill calls for a Financial Stability Oversight Council (FSOC) that would oversee the Federal Reserve and other agencies.  The nine-person FSOC would be chaired by the Treasury Secretary, and consist mainly of members drawn from the Securities & Exchange Commission (SEC) and other agencies.  It would make recommendations to the Fed and agencies under its purview, and at its discretion, step in to oversee regulation of financial institutions. 

Certain questions come to mind immediately regarding the proposed FSOC: 

• Is it necessary, and will it do the job Sen. Dodd thinks it will do?  Or is it just another layer of bureaucracy – an agency set up to oversee an agency that failed (specifically, the Federal Reserve, but there is blame to go around)? 
• Will it help mitigate the problem of “regulatory capture” at the Fed and elsewhere?  Might it in fact have a negative effect on regulatory oversight? 
• Will the FSOC “at its discretion,” adequately regulate non-bank financial institutions; break up “too-big-to-fail” financial institutions, particularly if they appear to be in distress; and rein in proprietary trading, investing in hedge funds, and other high-risk bets, particularly for firms that have access to the Fed’s discount window?

First, it seems unlikely that the FSOC will address the principal reason the Fed and other “leaders” in economics and finance failed to see, ignored, or downplayed the looming danger to the economy created by the tech and housing bubbles during the past decade: Deregulation of financial services entities.  The FSOC will be headed by the Treasury Secretary.  Treasury Secretaries in modern administrations almost always come from the financial sector, and bring a bias favoring the industry to the job.  Typically, after their tenure, they also return to the private financial sector, where they garner enormous salaries.  That should be of concern. 

Clinton Administration Treasury Secretaries Robert Ruben and Lawrence Summers agreed with Alan Greenspan on deregulation of derivatives, and repealing the Glass-Steagall Act (Depression-era legislation that walled off commercial from investment banks).  Clinton reappointed Greenspan twice, confirming that the 30-year doctrine of deregulation and unfettered markets that began in the early 1980’s has been bipartisan. 

Had an FSOC existed five years ago, would John Snow (Bush Treasury Secretary) or Securities and Exchange Chair Christopher Cox have been likely to demand that Alan Greenspan raise interest rates, increase capital requirements, or take other steps to restrict the money supply when (for the moment, at least) everything looked rosy?  In fact, there is no reason to expect that the FSOC headed by presidential appointees will be any more immune to either an administration’s political imperatives, or to the natural industry preference for deregulation, even with signs of trouble on the horizon. 

Nothing has changed, or will be changed by this bill, to make us expect that Timothy Geithner, Obama’s Treasury Secretary, will pay less attention to the corporate members of his former employer, the Council on Foreign Relations (Goldman Sachs being a senior corporate member, for example) and more attention to the Consumer Federation of America.  So it seems unlikely that an oversight committee headed by a Treasury Secretary and populated by members from the SEC is likely to instill any greater financial sobriety than what we have now. No one wants to take away the punchbowl when the party is in full swing, and the FSOC won’t change that.

The Fed’s failures between 1997 and 2007 are partly due to its cozy relationship with the people and institutions it was supposed to be regulating.  And since the Treasury Secretary, who would head the FSOC, so frequently comes from the upper echelon of the financial industry, why would we expect a less-cozy relationship between the industry and the FSOC?  The Chairman of CitiGroup had much more access to Greenspan and (then Chairman of the New York Fed) Ben Bernanke than, say a labor leader or consumer advocate.   That’s true of the Treasury Secretary, too.  The interest of the financial sector in deregulation does not coincide with the national interest, as we now know.  The creation of a Financial Stability Oversight Council, as envisioned, cannot credibly be counted on to re-regulate a highly deregulated financial sector.

One way to make the relationship between the regulators and the regulated less cozy would be to close the revolving door from government that leads into the lobbies of our major banks.  Dodd’s bill fails to address this vital issue.  Former employees of the Fed, Treasury, the proposed FSOC, and other regulatory bodies should be prohibited from working in finance for a period of several years, at least, after they leave office.  Conversely, if a financial sector executive joins a regulatory authority, there should be a “cooling off” period during which they are prohibited from any official role in the design or implementation of regulations or bailouts.

Economists and policymakers broadly agree that three areas need urgent attention:

1. The need to include “non-bank” financial institutions like AIG in the purview of financial regulatory oversight.
2. The need to break up or rein in giant financial corporations, whose failure could pose a systemic risk to the financial system.
3. The need to prohibit commercial banks and non-bank financial institutions from engaging in proprietary trading (this term is often not well defined, but generally means trading using the bank’s capital, rather than customer’s deposits); and from investing in hedge funds and private equity funds.  This is particularly relevant for institutions that benefit from federal protection on consumer deposits and access to the Fed’s discount window.  This is known as the “Volcker Rule,” and some say it should be extended to investment banks as well. 

The Senate bill calls for these actions to be carried out “at the discretion of the FSOC.”  The close relationship between the Treasury (and by extension, the FSOC), the Fed, and the regulated institutions makes it less likely that these issues will be adequately addressed under the FSOC, and more likely that the status quo will prevail.  This is particularly true given the requirements set forth in the bill.  A 2/3 vote of the Council would be required to break up a large, complex company that poses a grave risk to the financial stability of the U.S. economy.  Similarly, a 2/3 vote would be required to agree to regulate a non-bank financial institution.  The Volcker rule may or may not be implemented, depending on the recommendation of the FSOC (and the non-bank financial industry is strongly opposed to more oversight).

So the FSOC could be little more than a rubber stamp for bad decisions by the Fed, and it could also block good decision.  A more effective approach would be to write the rules into law.  If you want to regulate systemically important non-bank financial institutions, why leave it to the discretion of the FSOC.  Write the regulations into law.  If you believe we should break up “too-big-to-fail” financial institutions, break them up under the law, rather than leaving it to the FSOC.  If you want to limit proprietary trading, make it the law.

 

Consumer Financial Protection Agency

The Obama Administration has pushed for an independent Consumer Financial Protection Agency that would take over the consumer protection functions from all of the existing federal financial regulators.   Given regulators’ focus on “safety and soundness” responsibilities, it is to be expected that they place more weight on this than on consumer protections, particularly when there is a conflict between the two.  And there exists a fairly high potential for conflict.  Banks will only persist in activities opposed by consumer advocates if those activities are highly profitable.  Profitability leads to accumulation of capital, and thus, promotes the long term “safety and soundness” of the institution.  Regulators listen carefully to industry arguments about the value of products, or practices that promote institutional safety and soundness.  This gives regulators a natural propensity to favor the industry viewpoint over consumers.

Republicans and financial industry opponents to an independent agency are deeply concerned about the “consumer bias” such an entity would have, and have argued that an independent CFPA could have unintended negative consequences for the industry and ultimately for consumers.

Sen. Dodd’s bill does not include an independent CFPA, but does provide certain firewalls to ensure a level of independence for the agency.  It would require the CFPA to perform risk-reward analyses in order to assess and balance conflicting interests between institutions and consumers.  The bill also recognizes and addresses the fact that smaller banks could be hard hit by consumer protection oversight, given that most do not have large compliance departments to deal with numerous regulatory requests.

Dodd’s compromise on consumer protections is to house the CFPA at the Fed, but gives it a presidentially appointed director; funding by, but budgetary independence from the Fed; and considerable autonomy.  To check potential CFPA overreach, a 2/3 majority of a regulatory council could override CFPA decisions.  Banks with less than $10 billion in assets would not deal directly with the CFPA, but would still be supervised by their existing regulators.  And the CFPA would have powers over many non-bank financial institutions.

The FSOC will have broad ability to write rules governing mortgages, credit cards, and the so-called “shadow banking” system of payday lenders, debt collectors, and loan originators and servicers (including mortgage loan originators who played a very large role in creating the sub-prime mortgage debacle).  Firms that create, package, and sell asset backed securities such as mortgages will have to carry some of the risk – at least 10%, under the proposal – of the assets they sell. This will help to reduce systemic risk to the financial system by forcing mortgage brokers like Countrywide to follow stricter lending standards, making another sub-prime mortgage debacle less likely, and similarly protect consumers from unscrupulous lenders willing to make loans they know can’t be repaid.  

In general, the compromise that Sen. Dodd proposes is a good one.  There are reasonable arguments on both sides, for and against greater independence for the CFPA.  Given the opposition in the industry and on the right, Dodd has come up with what should be a workable approach for protecting consumers.

Enhanced Resolution Authority and the “Too-Big-to-Fail” Problem

There is broad agreement that enhanced authority is needed to intervene and resolve troubled, systemically important financial institutions that would pose a risk to the financial system if allowed to fail in a disorderly fashion.  Currently, Fed regulators have the authority to intervene when a bank gets into trouble, but much less ability to intervene when non-bank financial institutions face difficulties that pose a threat to the system.  Enhanced authority would have provided better tools to deal with AIG, Lehman, Bear Stearns, and others.   

Rather than allowing already huge financial institutions (Wells Fargo, Bank of America) to take over systemically important troubled institutions such as Wachovia and WAMU, they should be liquidated in an orderly manner, or where appropriate, go through a bankruptcy process.  Depositors can be mostly protected by FDIC insurance, and shareholders would incur some significant losses in either approach.  But allowing highly leveraged takeovers simply further consolidates an oligopolistic financial sector and dilutes capital-asset ratios from an already weak position.  We now have too-big-to-fail institutions that are much larger than before.  This is neither good for the financial system, nor good for consumers.  We’ll get to the topic of capital requirements for these massive institutions shortly.

Obama has favored giving regulators power over troubled, systemically important non-bank actors, much like the FDIC has power over troubled banks.  Such power would mean moving away from bankruptcy procedures, which give the parties involved an opportunity to make their case to a bankruptcy judge, and to bargain with each other over an extended period.  Regulatory power would give regulatory officials the power to make important choices very quickly, with little recourse for affected parties.  Quick, decisive action is called for when a crisis becomes apparent.

More importantly, bankruptcy generally precludes government bailout with taxpayer money (General Motors notwithstanding).  A resolution process run by bureaucrats and guided, to some extent, by politicians, would tend to pull in taxpayer money in order to keep systemically important institutions operating in order to avoid economy-wide negative repercussions.  Much as that may be unpopular, it is sometimes necessary in a crisis.  The key to protecting taxpayers, and the economy generally, of course, is to implement new rules that make crises less likely.  As we’ll see, this bill takes some important steps in that direction, but does not go nearly far enough.

Dodd takes an approach favoring bankruptcy in all but the most extreme cases, where systemic risk is an issue.  Bankruptcy would be used unless all relevant regulators, including the Treasury Secretary, certify that system-wide risk is an issue.  Thus, resolution, the winding up and liquidation of assets and liabilities, would not be entered into lightly under these rules.  This helps to protect taxpayers by reserving bailouts for those cases where there is no better option.  Further, by relying heavily on bankruptcy, the “moral hazard” problem, in which stakeholders and creditors assume a government bailout, is mitigated, since creditors and stakeholders are more exposed to losses than they have been in the past.

Dodd proposes a “Resolution Fund” that could be tapped to cover the costs of winding up the affairs of troubled financial institutions.  There is wide agreement over the need for such a fund, but much disagreement over the details.  Most agree that the financial industry should fund it, but industry officials are pushing to fund it “after the fact.”  Pre-funding through premiums assessed on industry participants assures that the industry, rather than taxpayers, foots a larger part of the bill for future resolutions.  Premiums should be related to the likelihood a firm will be a recipient, since this creates an economic disincentive to taking on large, highly leveraged portfolios of the riskiest bets.

Despite earlier proposals for a Resolution Fund of $100 billion, Dodd proposes a fund of only $50 billion, in a nod to the industry and Republican sentiment.  Given the lessons of the last crisis, $50 billion will be woefully insufficient in a severe future crisis.

The “bankruptcy-first” proposal also presents some problems.  The largest financial companies, while built around a major bank, have many non-bank affiliates.  Indeed, the bank holding companies themselves are not banks.  Yet these firms operate in a highly integrated way.  It becomes a question how you deal with many of the non-bank pieces, while perhaps using resolution for the core bank.   The two approaches, bankruptcy and resolution, could end up working at cross purposes, and even discourage regulators from intervening as early, or as effectively, as they might. 

The Resolution Fund is an attempt to create a system where taxpayer bailouts would be precluded or at least limited in a crisis (without actually funding it sufficiently to succeed).  In a severe crisis, with an underfunded Resolution Fund and a preference for bankruptcy (a preference made stronger by the mere fact that funding available for resolution is insufficient), losses to stakeholders and creditors would ricochet through the financial system and reverberate into the broader economy, as a wider and wider range of institutions suffer a domino effect of losses.  It is specifically this domino principle that makes an institution systemically important.  The result of multiple bankruptcies and liquidations would create a severe credit crunch, since firms going out of business make few loans.  Therefore, a much larger Resolution Fund, and/or a more flexible system that recognizes the potential need for a taxpayer bailout is required.

Bankruptcy is not particularly well equipped to deal with large, systemically important institutions that get into trouble.  These firms have effects on the larger economy that exceeds that of industrial or service firms of similar size.  It is precisely for this reason that the 2009 taxpayer-funded bailout was necessary.   Bankruptcy is a slow process, in which assets are divided up among creditors and other stakeholders.  Even one large, systemically important firm can precipitate a crisis that needs swift and decisive action.   Bankruptcy judges rarely have the experience, and certainly lack the legal basis, for managing bankruptcy for systemically important institutions in ways that might avert a severe crisis.  Bankruptcy decisions for systemically important firms have societal and economic impacts that go beyond the legal authority of bankruptcy judges to consider. 

Raising capital-asset ratios has also been widely discussed as a way to manage systemically important, “too-big-to-fail” financial institutions.  Essentially, the question is, “Can you achieve the goal of protecting the system by imposing capital requirements that increase with the size and importance of the institution?”  Is raising capital-asset ratios a possible alternative to breaking up “too-big-to-fail” institutions?  Consideration of asset ratios should be part of any reform, but what is the right amount?  And who should decide?  There is thus far no consensus on this issue. 

If capital-requirement decisions are delegated to regulators, will those regulators be subject to political pressure or “regulatory capture?”  There is evidence that they have been in the past.  The Office of Thrift Supervision has been a favorite regulator among financial institutions, thanks in part to lax oversight of asset values and quality.  When the regulator fails to accurately assess an institution’s assets, capital-asset ratios are likely to be set too low.  Regulators, at this point, being partly responsible for the current mess, are simply not credible decision-makers in this area at this time. 

An approach that presupposes that either unelected U.S. government regulators or Congress can get capital requirements right is a dubious proposition.  Both appear to have little resolve in resisting pressure (or accounting tricks) from the big banks.  Furthermore, these large financial institutions are all multinational players.  Setting U.S. capital-asset ratios higher than, say, DeutcheBank or UBS would put American-based financial institutions at a competitive disadvantage over foreign institutions.

Thus, there are good arguments for an international approach to financial sector reform, particularly where capital ratio questions and the need for a cross-border resolution authority that could step in when multinational financial institutions get into trouble.  Dodd’s bill does not appear to address the international aspects of banking, despite the fact that all of the largest, systemically important institutions have global reach.

There has been discussion among many economists of forming a “cross-border resolution authority,” perhaps under the auspices of the G-20.  The international authority could decide who would be in charge of winding up the business of a distressed global financial institution, and with what cash.  Because of the international nature of the financial system, any effort that is only in the U.S. will not rein in the largest institutions at all, and could encourage them to shop for a home in the country most willing to give them a free hand.  Unfortunately, with strong U.S. opposition assured, cross-border resolution authority will not happen soon.

For multinational financial institutions, international capital requirements are recommended by the Basel Committee.  In December, 2009, the Committee issued a consultative document proposing (among many reforms) modification of bank capital requirement.  The proposed reforms are intended to address lessons learned from the financial crisis.  The capital proposals are detailed and include raising the quality, consistency and transparency of the capital base; strengthening the risk coverage of the capital framework; introducing a leverage ratio requirement as an international standard; and measures to promote the build-up of capital buffers in good times that can be drawn upon during periods of stress, introducing a counter-cyclical component designed to address the concern that existing capital requirements are pro-cyclical – that is, they encourage reducing capital buffers in good times, when capital could more easily be raised, and increasing capital buffers in times of distress, when access to the capital markets may be limited or they may effectively be closed. 

The proposed Basel reforms appear to be positive steps toward mitigating both national and multinational systemic risks, though the comment period is still open, and reforms are still at least a year off.  Further, the proposed reforms are only recommendations that must subsequently be adopted by individual countries.  For Dodd, it may be a better political strategy to deal with capital requirements only once, after the Basel Committee has formally adopted the final recommendations, including any changes that may come out of the comment period.

Raising capital requirements has the salutary effect of making shareholders feel that when a bank takes a gamble, their capital is at risk.  And, since Dodd does offer shareholders more say in corporate governance, shareholders who are concerned about the risks that managers are taking with their money will have somewhat more recourse (though much of it “non-binding”). 

Under current regulations, a bank like Goldman Sachs has only an 8% capital-asset ratio.  So for $13 billion in assets (of unknown risk, since the regulators are so poor at assessing risk), Goldman only needs to put up $1 billion.  That is quite a lot of leverage, and it is currently the taxpayer that is taking that risk.

Capital requirements, essentially shareholder ownership, are an “equity cushion” that can absorb a financial institution’s losses if things go badly.  Capital requirements in the 6% or 8% percent range of assets is a quite modern idea.  In the mid-nineteenth century, banks financed a large percentage of their assets with equity.  A low equity cushion made sense when banks were tightly regulated and limited in the risks they could take; say from 1935 to around 1980.  But with the collapse of effective regulation over the past two decades, low capital requirements at leading banks (in combination with limited liability of shareholders) are inappropriate for maintaining a stable financial system or for protecting taxpayers. 

While capital requirements are a vital component to reform, and would be best addressed multilaterally, they cannot be depended on as a cure-all.  Capital-asset ratios that are progressively higher for larger and more systemically important firms can be an important disincentive to growing so large in the first place, but are unlikely to provide an adequate incentive to an already-too-large firm to divest.  A stable financial system can theoretically be based on either effective regulation or high capital asset ratios.  Think of it as a continuum between two poles.  In practice, of course, the trick is to find the right balance for each institution, particularly those of systemic importance. 

Dodd’s proposal is to let the FSOC determine if and when break-up of a firm is called for.  A far better approach would be a law that breaks up the largest firms now, strengthens regulatory oversight, and constrains the size of financial institutions in the future by effectively setting capital requirements with international cooperation. 

There is one other important issue to consider with regard to apportioning responsibility when a large, systemically important financial institution gets into trouble.  Like shareholders, managers and boards of directors should also have a substantial amount of skin in the game.  If their company fails, they should lose a portion of past salaries and bonuses under clawback rules that include all forms of remuneration, including stock options.  Dodd’s proposal wisely addresses this issue. 

Richard Parsons, the chair of Citigroup since February 2009, is estimated to be worth more than $100 million. Yet he reports that he owns only around $750,000 of Citi stock.  Such negligible personal downside risk for the board of directors is the norm in high finance today.  We should let bank executives be paid well when they are successful–but they should truly lose if they take risks that lead to failures and taxpayer bailouts.  Dodd’s proposed clawback policies will force managers to focus more on long-term growth and stability and less on short-term profits based on high-risk asset portfolios.

The Division of Regulatory Authority

The current state of financial sector regulatory authority is not what anyone would design if starting from scratch.  There exists a hodgepodge of agencies, often competing with each other and so not working in the best interests of financial system stability.  Everyone seems to agree that there are too many entities, but each has strong constituencies, so reducing the number is not easy.  Currently, we have:

• The Office of the Comptroller of the Currency (OCC) for national banks;
• State regulators for banks with state charters;
• The Federal Reserve, regulating bank holding companies and acting as the federal regulator for some state-regulated banks;
• The Federal Deposit insurance Corporation (FDIC) acting as the federal regulator for the remaining state-regulated banks, and for all banks with deposit insurance;
• The Office of Thrift Supervision (OTS) for federal thrifts (which are now essentially operated the same as banks);
• The National Credit Union Administration (NCUA), regulating credit unions (which are also essentially operated as banks, though depositors are called “members.”)

OTS has done a particularly poor job – they are tagged with the failures at AIG, Countrywide, and WAMU – but still gets strong backing from the thrifts and other institutions it regulates.  Perhaps enthusiastic backing of the regulator by the regulated entity ought to be seen as a red flag to begin with, especially given the ability of banks to modify charters and by doing so, select the regulator they want (called “charter shopping” in the financial industry.  Dodd’s bill does not address that issue.).

Unlike markets, where competition can result in innovation and efficiency, competition among regulators that are funded by fees levied on the entities they regulate can lead to lax oversight.  Competing regulators have an incentive toward leniency, particularly when institutions are permitted to charter shop, because lax regulation will attract more fee-paying institutions, enlarging the bureaucracy’s turf and budget.  Lax oversight can help financial institutions grow more quickly by taking bigger risks, giving them a competitive advantage over institutions under firmer oversight.  But it also increases the risk of bank failure, and the problem becomes more acute with time – ultimately setting the stage for a potential crisis.

The Obama administration has focused mainly on what the regulations ought to be, rather than on who should do the regulating.  This is not surprising, since adding in efforts to merge agencies would add a further layer of political difficulty to passage of reform.  Sen. Dodd initially wanted to wrap the regulators into a single body, but political opposition for such a proposal is strong.

Dodd’s compromise proposal is to merge only OTS and the OCC.  This was also part of the House-passed legislation and is favored by the administration.  He also reshuffles some responsibilities, but doesn’t eliminate agencies.

Under Dodd’s proposal, the Fed would regulate systemically significant non-banks, and solidify control over banking groups with more than $50 billion in assets.  But the Fed loses control over smaller, state-regulated banks, which would be picked up by the FDIC.  Thus, the FDIC would cover all state-regulated banks under the proposed bill.

Dodd also tries to address the influence that regulated companies have over the Fed and other financial regulatory agencies.  Of course, the structure of the Fed institutionalizes the influence that banks have over it.  It was created as a semi-private agency, and officers of the Regional Federal Reserve Banks are appointed by bankers who serve on the boards of directors of banks (and those banks select their boards, so it’s all rather incestuous).  The Chairman of the powerful New York Federal Reserve has a permanent seat on the Open Market Committee that makes decisions on U.S. monetary policy.

Dodd proposes that the Head of the New York Fed be appointed by the President, and confirmed by the Senate.  He also wants the companies that the Fed supervises no longer be allowed to vote for the directors of the regional Federal Reserve Banks.  Bankers from companies like Morgan Stanley will no longer be able to serve on Regional Federal Reserve Banks’ Boards of Directors.  These are small steps toward limiting undue banking-sector influence over Fed decision-making.  Much more is needed.

The Fed did not create our current atmosphere of deregulated risk-taking. But neither is the Fed blameless, since Fed chairmen and boards have encouraged deregulation right along with Congress and both Democratic and Republican administrations.  The Fed is partly a prisoner of the current system–but it is also partly a jailer. In the moments when the Fed is presented with a rescue-the-banks-or-the-economy-will-collapse scenario, it is a prisoner. But the Fed, and especially the Fed Chairman, has plenty of power to shape the environment that produces this choice.  And it has taken on the challenge of shaping the financial climate before.

During the 1930s, Fed chair Marriner Eccles was an advocate for change across the financial system. Now, Bernanke needs to play the same role. He needs to advocate for rules and regulations that ensure financial leaders will bear serious costs when there is a future failure due to excessive risk-taking. Otherwise, the Fed will continue to be held hostage to repeated bailouts. And, with each bailout laying the groundwork for the next one, the peril facing our financial system will only grow worse.

 

Regulation over trading of derivatives, asset-backed securities, and hedge funds

Dodd’s bill proposes new regulations over trading of over-the-counter derivatives, asset-backed securities, and hedge funds.  There would be more trading on exchanges and through centralized clearinghouses and all trades would have to be reported.  Over-the-counter derivatives would be regulated by the SEC and the Commodity Futures Trading Commission (CFTC).  Hedge funds with over $100 million in assets would be required to register with the SEC as investment advisors and to disclose financial data needed to monitor systemic risk.  Given that this was an estimated $592 trillion market in 2008, these reforms are long overdue.

New rules for financial brokers, investment advisors, and credit rating agencies,.

Dodd proposes new rules that will improve transparency and accountability for investment advisors, financial brokers, and credit rating agencies. 

The bill has rightly disappointed investor advocates for its failure to include a provision that would require securities brokers to act in their clients’ best interests.  Many investors think that their investment brokers already have a fiduciary responsibility to work in their best interests, but this is not the case.  There is a fundamental legal distinction between investment advisors and financial or securities brokers.  The confusion is aggravated since brokerage firms now often call their salespeople “financial advisors,” and there no longer exists a clear line separating brokers from advisors.  Some brokers are dually registered as brokers and investment advisers and can wear both hats, even when working with the same customer.  Still, under the law, brokers and investment advisors have different obligations to their clients, and are subject to different laws and regulations.

People who get paid for giving comprehensive and continuous investment advice must register as investment advisers with the Securities and Exchange Commission. They are regulated by the Investment Advisers Act of 1940, and under that law, have a fiduciary duty to their clients. Quite simply, this means they must act in the client’s best interests.  They must avoid conflicts of interest, and disclose them when they exist.  Thus, when they sell stocks or securities from their own firms, they must follow strict disclosure rules.

A broker, by comparison, is a salesperson who primarily helps clients trade stocks and other securities, although (s)he may provide advice that is “solely incidental” to the trade. Brokers sell securities from their firms’ accounts to clients on a regular basis.

Brokers are not fiduciaries. They are not required to put a client’s interest ahead of their own or their firm’s interests.  Brokers are required to know their customers and make “suitable” recommendations, but they do not have to recommend the cheapest or best security.  The problem is that they can satisfy the suitability standard by offering the least suitable of the suitable products, and may do so even if, among the range of suitable options, the highest-cost, worst performing investment makes particularly generous revenue-sharing payments to the broker’s firm.

The fiduciary standard applied to investment advisers means that if something goes wrong and you end up in court, the advisor has to prove he went through a process to make sure the recommendation was, and continued to be, in the client’s best interest.

Investor advocates want the SEC to hold brokers, including insurance salespeople who sell variable annuities, to the same fiduciary standard as investment advisers.

In December, the House passed a bill that would require the SEC to impose a fiduciary duty on brokers when they give personalized investment advice to retail clients.  That language was not as tough as a bill that Dodd had introduced in November, but investor groups were willing to accept it. They wanted Dodd to include it in the replacement bill he recently introduced.

He did not. Instead, the new Dodd bill requires the SEC to conduct a one-year study to determine whether a fiduciary standard should be extended to brokers. The bill tells the SEC to “adopt rules to address any gaps in investor protection it identifies in the study.”  Recent history and the blurred lines between investment advisers and securities brokers make the need for additional “study” unnecessary.  The facts are in and brokers ought to be required to put their client’s interests first.  Period.   

The securities industry wants the SEC to adopt a single fiduciary standard that would apply equally to investment advisers and to brokers giving personalized advice to retail customers, and it wants this standard to trump any state standards.  Investor advocates want states to be able to impose higher standards.  That is an argument over details, but in the interest of clarity and to minimize a patchwork of state-level regulation (which we now have), a single set of strict rules ought to apply.

Dodd proposes that credit rating agencies be overseen by a new Office of Credit Rating Agencies (OCRA) at the SEC.  Ratings agencies will be required to register with this office (registration with the SEC is now voluntary for ratings agencies).  New rules will improve internal controls, and enhance independence and transparency.

Flawed methodologies, weak oversight by regulators, conflicts of interest, and a lack of transparency in the rating process allowed AAA ratings to be conferred on complex, unsafe, asset-backed securities.  This added to the growth of the housing price bubble and magnified the shock when it collapsed.  Untrustworthy ratings and growing lack of confidence in ratings made lenders apprehensive about lending to finance asset purchases.

The new OCRA will have the authority to examine ratings agencies and make their findings public.  Agencies will have to disclose their methodologies, including use of third-parties for due diligence efforts.  Ratings track records will allow regulators and others to determine when agencies consistently come up short on the quality of their ratings.  The SEC will have the power to de-register an agency providing bad ratings over time.

Since ratings agencies are paid by fees from the institutions whose products they are rating, there is an inherent conflict.  Many new rules will help to limit these conflicts of interest.  For example, ratings agencies will be prohibited from providing consulting services to companies that contract for ratings of securities. 

A “look‐back requirement” will address conflicts from a “revolving door” between ratings agencies and issuers of securities.  If a rating agency employee is hired by an issuer and if the employee had worked on ratings for that issuer in the preceding year, the rating agency will be required to conduct a review of ratings for that issuer to determine if any conflicts of interest influenced the rating and adjust the rating as appropriate.

The bill also requires disclosure of “preliminary ratings.”  Currently, an issuer of a security may attempt to “shop” among rating agencies by soliciting “preliminary ratings” from multiple agencies and then only paying for and disclosing the highest rating it received for its product. Dodd’s proposal would shed light on this practice by requiring an issuer to disclose all of the preliminary ratings it had received from different credit rating agencies so that investors will see how much “shopping” happened and whether there were discrepancies with the final rating.

Conclusions

Dodd’s bill falls short in adequately addressing issues of consolidated and effective regulatory authority, curbing industry influence over regulators, stiffer rules on capital ratios, and more.  Like Democrats in the healthcare debate, he would have us believe that “you can’t get there from here” given the political climate.  Given the public’s anger at the banking industry, it would seem that now is precisely the time to act boldly.  Nonetheless, Dodd’s proposals in the most of the areas discussed here are reasonable, represent substantial improvements over the status quo, and should limit the worst abuses.