Dodd-Frank must be the first – not the last – step in a long-term restructuring of financial markets

By Michael Prowse, Senior Visiting Fellow

After Britain’s first military victory against Germany in the Second World, at El Alamein in Egypt, Winston Churchill cautioned against excessive optimism. “This is not the end,” he said. “It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

The American public should regard the Dodd-Frank financial regulation bill rather as Churchill regarded Rommel’s defeat in Egypt – as an encouraging sign of progress but as by no means guaranteeing that Wall Street will eventually serve the interests of the nation as a whole.

The new law gives a network of new regulatory agencies greater discretionary powers over financial firms but it does not fundamentally alter the structure of the banking industry. There can be no guarantee that supervisors will possess the expertise or will to exercise their discretion wisely. Nor can we be certain they will be capable of predicting future crises soon enough to impose precautionary measures, such as increased capital requirements. Life looks set to continue pretty much as usual on Wall Street.

Dodd-Frank admittedly breaks new ground in several ways. It purports to solve the “Too Big To Fail” problem by creating an “orderly liquidation authority” which can seize failing banks, force creditors to accept losses and meet shortfalls with a retrospective levy on financial firms, rather than taxpayers.

The new Financial Stability Oversight Council, chaired by the Treasury Secretary, will bring together the heads of the main regulatory agencies. The hope is that if information is pooled regulators will have a better chance of identifying emerging systemic risks.

In addition Dodd-Frank will ban some proprietary trading by banks (but how much is not yet clear), It will oblige banks to spin off about a third of their derivatives business; standardised, but not exotic, derivatives will have to be traded on exchanges.

The bill also creates a Consumer Financial Protection Agency to regulate the sale of mortgages and other financial products to consumers. In theory such an agency could reduce the information asymmetry that places such power in the hands of financial firms. But whether it does will depend on how it is led.

Dodd-Frank seeks higher capital requirements for banks but leaves the details blank because the US is waiting for the outcome of international negotiations under the auspices of the Basel Committee on Banking Supervision (“Basel III”). The Basel group has proposed counter-cyclical capital requirements –i.e. that banks strengthen their balance sheets during the boom phase of the business cycle so as to prepare themselves for the bust phase. But banks are already lobbying hard against the mooted Basel reforms.

Dodd-Frank’s general philosophy (which reflects that of the Obama administration) is that the present structure of financial markets is basically sound. All will be well so long as a range of supervisory mechanisms is tightened up, and so long as modest restraints are placed on the most risky activities of the very large interconnected financial institutions – those that hitherto have been regarded as Too Big To Fail.

Although Dodd-Frank may represent the limits of the politically possible, even for a Democratic administration that controls both houses of Congress, it is fair to ask whether it is sufficiently radical.

Just consider what has happened. The financial industry extracted rent from the US economy on a massive scale over several decades: the Financial Times estimates that financial sector profits rose 800 per cent in real terms between 1980 and 2005 against 250 per cent for non-financial firms. As a result of greedily agreeing risky contracts they did not understand, the largest banks around the world then succeeded in collectively bankrupting themselves.

Taxpayers rescued them at enormous expense – in many countries debt to GDP has doubled as a result of the bailouts. Meanwhile the financial turmoil caused the worst global recession since the 1930s. Although bankers’ bonuses are again at record highs, scores of millions of workers remain jobless.

Given the scale of the financial sector’s failure, on might have hoped for tougher action. Both equity and efficiency demand it.

In the 1930s, the Glass-Steagall Act did not content itself with promises of vague future controls on some proprietary trading. It made financial firms choose irrevocably between commercial and investment banking, and it forcibly broke up the House of Morgan. Top bankers were not just summoned to testify before Congress; they went to jail.

By contrast Dodd-Frank is imposing reforms that are expected to cut profits at Goldman Sachs and J P Morgan by just 9 per cent – and that will be temporary because their armies of lawyers will soon find loopholes in the legislation.

The biggest weakness of Dodd-Frank is its pervasive reliance on unspecified discretionary interventions by regulators. History suggests regulators tend to internalise the assumptions of those they regulate. For instance, even if regulators have the power to impose significantly higher capital requirements during apparently good times, will they in fact do so? In practice they will do so only if they predict future trends better than financial firms and if they have the support of their political masters.

Neither condition can be guaranteed. Banks are very effective lobbyists and will argue that more capital means higher borrowing costs for consumers. And suppose there is a Republican administration. Will regulators with a free market ideology use their discretion to impose tough restraints on top financial firms?

Similar considerations apply to other aspects of the legislation. Suppose Citigroup gets into difficulties again. Can we be sure that regulators will use the new liquidation machinery? Will they seize its assets, impose heavy losses on creditors and wind it up, and then seek billions in compensation from financial firms that were well managed?

Again it depends on political will. In practice a future administration will worry about contagion effects if it imposes losses on Citigroup’s creditors. And given that the White House was not willing to let General Motors fail would it really be willing to wave goodbye to a financial titan? Might not critics argue that Citigroup must be saved on national competitiveness grounds? After all, they will say, the German government would always rescue Deutsche Bank just as the Swiss would always rescue UBS?

The inescapable conclusion is that more radical restructuring is required. There is nothing special enough about financial transactions to justify the enormous salaries and bonuses on Wall Street and other financial centres. Adair Turner, chairman of the British Financial Services Authority (and a career investment banker), has said publicly that much financial activity is socially useless and exists only because it is highly profitable for those in the industry. He thinks finance should shrink as a share of GDP.

The sector is also riddled with competitive distortions: chronic informational asymmetries; externalities and spill-over effects that create systemic risk; and reputational effects that prevent small entrants gaining market share. This is why remuneration is so out of line.

Financial services are oligopolistic rather than competitive, and the sector is dominated by very large conglomerates that are probably economically inefficient. There was no particular logic, for instance, in the bundling together of Citicorp (a retail bank), Salomon Brothers (an investment bank), Smith Barney (a brokerage) and Travelers (an insurance company) to create the gargantuan Citigroup – an institution that proved utterly dysfunctional in 2007/08. If it were not for the distortions of deposit insurance and the Too Big To Fail policy, each of these functions could be better performed by a specialist firm.

Dodd-Frank is better than nothing. But what is needed now is a fundamental re-examination of the grounds rules of finance.

In Britain, the coalition government has established a high-powered Commission on Banking to undertake just such a radical analysis. It will consider proposals such as “narrow banking” under which the utility and casino aspects of banking are firmly separated, and “limited purpose banking” under which banks are effectively turned into mutual funds and prevented from gambling with their depositors’ money.

The Obama administration should consider establishing a similar commission – with two crucial provisos. The majority of members should be independent of the financial services industry, and perhaps even of the present central banking/regulatory community. And they should be charged with restructuring banking so as to ensure it serves the public interest. The present goal of preserving “financial stability” is far from adequate.