Dodd-Frank: Three levels of containment

Bloomberg published an excellent editorial on the Dodd-Frank Act.  In particular, the editorial focused on how it uses three levels of containment to build a fail-safe system.

Regular readers know that I dislike every element of Dodd-Frank except for Elizabeth Warren's Consumer Financial Protection Bureau.

I think readers might find it interesting to see what Bloomberg saw as a positive and why I think Dodd-Frank is a series of one off solutions that do not address the real issues.

The vilification of Dodd-Frank is odd, given that most of the law has yet to take effect. The law firm Davis Polk & Wardwell LLP estimates that as of Dec. 1, only 74 of the 400 required rules had been finalized, and 154 had missed the law’s deadlines.

Actually, the vilification is justified.  The law was written before the watered down version of a "Pecora Commission", the Financial Crisis Inquiry Commission, reported to Congress on what it saw as the causes of the credit crisis.

As a result, there is little chance that it actually addresses what went wrong and a substantial chance that it reflects smoke and mirrors that let the financial industry continue along as if nothing happened.

Most people, quite understandably, haven’t had the time or patience to wade through the law’s 848 pages. As a service to them, we did so. What we found, admittedly cloaked in eye- glazing language, was an elegant core of sensible ideas. Consider it a fail-safe system with three levels of containment.

For those keeping score, the Pecora Commission resulted in a fail-safe system with one level of containment.  We know that simple system worked successfully for 70+ years.

The question is "in all of these new levels of containment, did Dodd-Frank fix what went wrong with the system based on the Pecora Commission's work?"

Level 1 is designed to make disastrous mistakes at financial institutions less likely. One central element is transparency: Bank stress tests, centralized reporting of derivatives trades and a data-analysis arm called the Office of Financial Research will give regulators, investors and journalists more information. They can use it to identify dangerous concentrations of risk in banks, investment firms, insurers and other financial entities.

Look at that, the central element of the level designed to make disastrous mistakes at financial institutions less likely is transparency.

Look at the benefit that transparency offers: the ability to identify dangerous concentrations of risk and, by implication, to adjust the amount and price of the market participant's exposure to those dangerous concentrations of risk

Is the Bloomberg News organization a fan of this blog?

However, the Dodd-Frank version of transparency comes straight from the Opacity Protection Team.  This is easy to show using the three examples provided by Bloomberg.

By themselves, bank stress tests provide no useful information.  Bank of America stock price appears to suggest that the market does not buy the results of its successfully passing the first Fed stress test and narrowly missing getting back its ability to increase its dividend under the second Fed stress test.  This problem with stress tests is global, just look at Dexia passing the European Banking Authority's stress test and needing to be nationalize 2 months later.

Regular readers know that the whole premise behind stress tests is flawed.  Rather than make each bank disclose its current asset, liability and off-balance sheet exposure details and let the market independently stress test each bank, the Fed does it for them.  Since when are the 100+ PhDs at the Fed better at analyzing data than the market which employs 1,000s of experts?

Even worse, when the Fed provides the results of its stress tests, it is explicitly offering investment advice and taking on the moral hazard that comes with offering this advice.  Once the Fed says that the banks are solvent and can pay dividends the Fed is on the hook for bailing out the banks for any solvency problems.  After all, why should any market participant believe the Fed is wrong given that it is the Fed that had access to all the current asset, liability and off-balance sheet exposure details?

Stress tests do not provide transparency, they maintain the reality that banks are, to quote the Bank of England's Andy Haldane, 'black boxes' to all non-regulatory market participants.  Black boxes are by definition opaque.

Call stress tests a victory for the Opacity Protection Team.

Next on the list is centralized reporting of derivative trades.

Regular readers know that there are two forms of transparency:  valuation and price.  Valuation transparency is defined as the buyer having access to all the useful, relevant information in an appropriate, timely manner so that they can assess what they are buying.  Price transparency is defined as showing the price of the last trade for a financial instrument.

Centralized reporting of derivative trades addresses price transparency, but not valuation transparency.

Everyone knows that price does not equal value.  As Warren Buffett says, price is what you pay and value is what you get.  With price transparency by itself, you do not know if it was a fair trade or the price a greater fool was willing to pay.

It turns out that in Economics 101 they teach that valuation transparency is the important form of transparency.  It is a requirement for the invisible hand to operate properly that buyers know about the good being traded.

This makes sense because before buying or selling a security, a buyer needs to assess the value of the security to see if they are getting a fair deal.  For example, if a buyer values a security at fifty cents, they are certainly not going to spend a dollar buying it.

Centralized reporting of derivative trades does not provide valuation transparency as the instruments being traded are still 'black boxes' (think opaque, toxic structured finance securities).

Call centralized reporting a victory for the Opacity Protection Team.

Last on the list of examples cited by Bloomberg is the data-analysis arm of the Office of Financial Research (OFR).  I personally think that OFR was the Opacity Protection Team's finest hour.

Just like stress tests, OFR is a barrier between the market and the disclosure of all the useful, relevant information by financial firms.

Once again, a government agency is being substituted for the market.

Please tell me why the PhD's who work for OFR are going to be superior to the PhD's that work at the Fed in their ability to analyze all the useful, relevant information for financial firms.  Then, please explain why they are going to be better at analyzing this information than the market with its 1000's of experts including competitor firms!

I call OFR the Opacity Protection Team's finest hour, because they were able to preserve the opacity in the financial system when everyone knew that valuation transparency was required.

For banks, transparency is the disclosure on an on-going basis of their current asset, liability and off-balance sheet exposure details.

For structured finance securities, transparency is disclosure of the terms of the deal as well as the current performance for each of its underlying assets.

Valuation transparency appears no place in the Dodd-Frank Act and quite simply, that is why I dislike it.

The law also rearranges some incentives. By stipulating that lenders must hold a portion of the mortgages they originate, Dodd-Frank reduces the temptation to make bad loans and sell them off to greater fools.

So long as there is valuation transparency, it is up to the buyer to determine how much exposure they want to 'bad' loans.

Stipulating the lenders hold a portion of the mortgages they originate simply increases their risk for no benefit.  If they want to hold 'bad' loans, they can do it directly in their loan portfolio.

By forbidding federally insured banks from engaging in speculative trading for their own accounts, the so-called Volcker rule limits a taxpayer subsidy that has encouraged traders at such banks to take outsized risks.

By requiring the banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market discipline can be applied to end proprietary trading without the need for regulation.

It is a trader's worse nightmare to have to disclose their positions.  Rightly or wrongly, they believe that the market will trade against them.

At a minimum, disclosure of the positions makes it easy for the market to identify market making activities and proprietary trades.

By requiring executives to write credible living wills describing how their institutions can be dismantled in bankruptcy, the law leans against banks getting too large or too complex to manage.

There is no such thing as a credible living will.  What we learned during the 2008/2009 period of the financial crisis is that there are no buyers at any price when market participants believe the problem is not specific to only one entity.

Requiring disclosure of their current asset, liability and off-balance sheet exposure details is far more effective at addressing banks that are too large or too complex.

Simply put, with access to the data, market participants become responsible for all gains and losses on their exposures to these banks.  This will put banks under significant pressure to reduce their size and complexity.  This is the result of the simple fact that the harder it is for market participants to analyze a bank, the riskier they perceive the bank to be and the higher the return they need to invest in the bank.

Bank management is very attuned to increases in its cost of funds.  As a result, they have an incentive to reduce the size of the bank (think assets that are no longer profitable to hold when the cost of funding increases) and complexity.

Level 2 aims to make financial institutions better able to survive when mistakes do happen. 

The crucial piece here is higher capital requirements. Like equity for a homeowner, capital allows a bank to stay solvent if the value of its investments falls. 

Capital requirement without transparency are, as the OECD observed, meaningless.

Everyone knows that banks have been practicing extend and pretend since the beginning of the credit crisis.  In addition, mark-to-market accounting was suspended.  Net result, bank assets and capital are over-stated.  Dividing one over-stated number by another over-stated number provides a meaningless number.

The failure to provide transparency in Level 1 means that higher capital requirement in Level 2 is of de minimus benefit.

Stress tests conducted by the Federal Reserve play a role, too. By simulating how a bank would fare in worst-case scenarios, they help ensure that banks don’t report fictitious capital....

Were he alive today, Mark Pittman would point out to Bloomberg's editors that the same Fed that concealed its loans to banks has no trouble with banks engaging in fictitious reporting.  After all, the Fed knew of these loans to the banks and the fact that the banks did not report them.

Remember, this Fed knew of the loans to less developed countries on bank balance sheets and never required these loans to be written down to market value.  If that is not comfort with reporting fictitious capital, I do not know what is.

Level 3 seeks to make sure that if a financial institution does fail, it won’t bring down the whole system. The law gives the Federal Deposit Insurance Corp. the power to take over a troubled institution and wind it down in a way that limits contagion -- a task made easier by living wills and better information on how financial institutions are linked....

Actually, the way the financial system is designed when there is transparency is that every participant protects themselves by limiting their exposures to what they can afford to lose.  There is seventy years of history showing that this is a robust solution.

The current financial crisis is the direct result of making the financial system dependent on a single point of failure.  In this case, the single point of failure was the bank regulators and their monopoly on all the useful, relevant information for financial institutions.

For whatever reason, the regulators failed to properly assess the risk in the financial system and communicate this risk to investors.

As a result, investors, including competitors, under-priced the risk and over-exposed themselves to losses.  It is this over-exposure that set up the situation where the failure of one bank could bring down the entire system.

The only way to limit contagion is by requiring the banks to provide ultra transparency.  It is with this data that market participants can assess the risk of each bank and properly set the amount of their exposure to it relative to its risk and the market participant's ability to absorb losses.

Dodd-Frank deliberately lacks a Level 4: It forbids the use of taxpayer money to bail out institutions whose failure could bring down the system....

Everyone believes that Congress will immediately vote to end this restriction should we face another systemic financial crisis -- after all, not doing so plunges us into a Great Depression.

However, because there is some chance that Congress will be so dysfunctional that it cannot vote to end this restriction, its inclusion in the Dodd-Frank Act is more than enough reason to repeal the Act in its entirety today.

Here is a case of Congress gambling with financial stability.

The solution is not to repeal Dodd-Frank. It is to construct its containment system as quickly as possible. The uncertainty over how the law should be implemented is probably its greatest flaw. The sooner rules are written and enforced, the sooner banks can learn to live with them and get on with the business of helping the economy grow.

Actually, the solution is to repeal Dodd-Frank.  A simpler, better containment system can be erected by requiring ultra transparency.