Tuesday, July 21, marks five years since President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The Heritage Foundation will observe the day with a two-part event. Opening remarks by Senate Banking Committee Chairman Richard Shelby (R-Ala.) will be followed by a panel discussion featuring University of Virginia Law School Dean Paul Mahoney, The Hill’s Kevin Cirilli, and yours truly.
The event will explore exactly why Dodd-Frank failed to accomplish one of its purported goals: ending too big to fail. Taxpayers today remain as much at risk as ever of getting stuck with the tab for future bailouts of mega-financial institutions.
Lest it take away too much fire from the event, this column will address only one Dodd-Frank-related issue: the animating myth that it was wild, unregulated speculation with derivatives that caused the 2008 financial crisis.
Many of the rules promulgated by federal regulators to implement the Dodd-Frank Act explicitly blame the crisis on American International Group’s (AIG) use of credit default swaps (CDS). For instance, in promulgating a rule for new swap market regulations, the Commodity Futures Trading Commission (CFTC) stated:
… AIG reportedly issued uncleared CDS transactions covering more than $440 billion in bonds, leaving it with obligations that it could not cover as a result of changed market conditions. As a result of AIG’s CDS exposure, the Federal government bailed out the firm with over $180 billion of taxpayer money in order to prevent AIG’s failure and a possible contagion event in the broader economy.
There are too many things wrong with this statement to cover in one column, so I urge you to check out our event for more details. (And AEI is having a similar event later in the day). One problem, though, is that the CDS themselves were not the main culprit in AIG’s financial difficulty.
Mercatus scholar Hester Peirce has documented that much of the difficulty at AIG stemmed from its securities lending business within its (non-bank) life-insurance subsidiaries. (Besides, the new Dodd-Frank clearing rules don’t apply to the highly specialized type of CDS that AIG used.)
The CFTC statement also implies that the swap markets were unregulated prior to Dodd-Frank. That’s factually incorrect, yet the claim remains pervasive in media accounts of the crisis and persists even in otherwise sound analyses of the impact of Dodd-Frank on derivatives markets.
So it bears repeating: swaps were not unregulated prior to the crisis.
True, the bulk of the swap markets was regulated by neither the CFTC nor the SEC. But that’s kind of like pointing out that banks are not regulated by the SEC. It’s largely irrelevant.
In reality, the overwhelming majority of the swap markets operated under the watchful eye of federal banking regulators, including the Federal Reserve and the Office of the Comptroller of Currency (OCC). These markets have always been dominated by large banks who use, mainly, interest rate and foreign exchange swaps. None of these transactions took place outside of bank regulators’ purview.
A 1993 Boston Federal Reserve paper notes that “The first and most popular use of swaps is to transform fixed-rate debt into floating-rate debt, and vice versa.” It concludes by noting:
Bank regulators have recognized the credit risk of swaps and instituted capital requirements for them and for other off-balance-sheet activities, as part of the new risk-based capital requirements for banks.
Need more proof? Here’s a passage from a 1996 bulletin from the OCC:
Bank management must ensure that credit derivatives are incorporated into their risk-based capital (RBC) computation. Over the near-term, the RBC treatment of a credit derivative will be determined on a case-by-case basis through a review of the specific characteristics of the transaction. For example, banks should note that some forms of credit derivatives are functionally equivalent to standby letters of credit or similar types of financial enhancements. However, other forms might be treated like interest rate, equity, or other commodity derivatives, which have a different RBC requirement.
And in 2006, just prior to the recent crisis, another OCC report stated:
As a result, derivatives activity is appropriately concentrated in those few institutions that have made the resource commitment to operate the business in a safe and sound manner. Further, the OCC has examiners on site in these large banks to evaluate the credit, market, operational, reputation and compliance risks in the derivatives portfolio on an ongoing basis.
The notion that these transactions took place in some shadowy, hidden room of finance, where regulators had no clue what was going on, is absolutely false. Not only did they know, they actually blessed the transactions as safe. Repeatedly.
More broadly, even AIG was regulated. And there was no substantial reduction in financial market regulations in any of the previous 10 decades. Many rules and regulations had been changed over the years, but virtually none were eliminated.
But these two big myths – deregulation and speculation caused the crisis – refuse to die.
Perhaps it’s tradition. The practice of blaming speculators for financial turmoil is as old as the hills. Back in the 1600s, the English Parliament blamed a major crisis on the “pernicious Art of Stock-jobbing.” In 1929, members of Congress blamed the stock market crash (and the Great Depression) on speculators. They subsequently used the event to radically alter federal regulations.
One major piece of legislation was the Glass-Steagall Act of 1933. It prevented – for the first time in the U.S. – commercial banks from engaging in many securities-related activities through companies known as securities affiliates.
Sen. Carter Glass argued that these affiliates “made one of the greatest contributions to the unprecedented disaster which has caused this almost incurable depression.”
Even though the evidence suggests combined commercial and investment banking activities did not cause excessive risk taking, much less the Great Depression, this myth persists to this very day.
Senators John McCain (R-Ariz.) and Elizabeth Warren (D-Mass.) have just introduced a new bill to reinstitute Glass-Steagall restrictions on commercial and investment banking affiliates.
Yet there’s not one shred of credible evidence that these affiliations, legally permitted by the 1999 Gramm–Leach–Bliley Act (GLBA), caused the 2008 financial crisis. It’s just as much a myth now as it was in the 1930s.
But it’s easier for Congress to blame “speculators” than to deal with the fact that regulators clearly blessed the transactions leading up to the 2008 crisis.
Aside from the above citations on derivatives failures, Congress largely ignored the fact that the GLBA kept the Fed in place as the primary regulator of bank holding companies. In this role, the Fed approved holding company applications only after certifying that both the holding company and all of its subsidiary depository institutions were “well-managed and well-capitalized, and…in compliance with the Community Reinvestment Act, among other requirements.”
But Congress absolved regulators – including the Fed – of any real blame for the crisis. Instead, it gave them even more power to regulate financial markets. Yet the underlying premise of all these new rules and regulations, that unregulated markets were to blame, is demonstrably false.
Decades of federal policies have helped save firms and their creditors from bankruptcy, and Dodd-Frank has done virtually nothing to reverse that trend.
Taxpayers should be under no illusions: they’re still on the hook when a new financial crisis hits.
Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies. He is also a co-author of Heritage’s Opportunity for All; Favoritism to None.”
