Dodd-Frank Was Designed to Fail – and Trump Will Make it Worse

By William K. Black
April 17, 2017     Bloomington, MN

William Cohan’s April 14, 2017 column in the New York Times discusses Daniel Tarullo’s swan song talk on bank regulation.  Here are the key passages from that column for the first half of my discussion.

Much to the relief of Wall Street executives, who feared and hated him in equal measure, Daniel K. Tarullo left his powerful perch on the Federal Reserve Board of Governors last week, but not before delivering one last lecture on how big banks should be regulated in his absence.

His swan song was pretty surprising, all things considered. It also went largely unnoticed, much like Mr. Tarullo himself during his eight years at the Federal Reserve. Many people have never heard of him, even though his decisions affected their lives in ways big and small.

Once described as the “Wizard of Oz,” for the power he wielded behind the scenes, Mr. Tarullo was appointed to the Federal Reserve by President Barack Obama in January 2009. At the Fed, Mr. Tarullo took over the important responsibility of regulating the big Wall Street banks, a job that, understandably, had been the purview of the president of the Federal Reserve Bank of New York. The oversight moved to Washington from New York in the wake of the financial crisis.

“It was obvious that a lot in the U.S. regulatory system had not worked particularly well before the crisis,” Mr. Tarullo said in a 2015 interview with The Wall Street Journal.

Cohan was writing about a different subject, one I discuss briefly in the second half of this article, so he did not discuss the insanity described in these four paragraphs.  Here is the short version of that insanity.

1.) The Clinton and Bush administrations, collectively, destroyed effective financial regulation. Tarullo’s sad euphemism is “the U.S. regulatory system had not worked particularly well before the crisis.”

2.) As you can tell from that sad euphemism, in a supposedly honest swan song, Tarullo is not the kind of enforcer who inspires real “fear” or “hatred” from an industry. The “Wizard of Oz” is an apt moniker “for the power he wielded behind the scenes” – for the Wizard of Oz was a pathetic huckster.  Here is a quick test of the fantasy that Tarullo was tough.  The Fed “removed and prohibited” what CEO of a prominent Wall Street bank under Tarullo?  The answer is no one.  The Fed never even attempted to remove a single one of the Wall Street CEOs that led the most destructive epidemics of financial fraud in history.

3.) As weak as Tarullo was, he was in fact far tougher than his predecessor who was responsible for regulating Wall Street’s commercial banks, which “understandably, had been the purview of the president of the Federal Reserve Bank of New York.” That president was the most abject financial regulatory failure in my Nation’s history – which is a powerful insult given how many U.S. presidents deliberately appointed scoundrels because the president knew that they would fail to even try to be effective regulators.

Who was that NY Fed “president” who was the worst-of-the-worst regulators that was so culpable in devastating our Nation?  That scoundrel must have had his reputation destroyed and been recognized as unfit to serve even as a dogcatcher in a one-dog town.  That would be the result if we did not live in the modern era of American crony capitalism.  In that real world, our presidents promote our worst scoundrels precisely because the scoundrels deliberately refused to honor their oath of office and regulate Wall Street.  In our real (depraved) world the new President Obama promoted the disgraced Timothy Geithner from his position as the president of the NY Fed to the top financial position in the world – Secretary of the Treasury.

Everyone in finance knew that Geithner had been a catastrophic failure as regulator.  Everyone in finance knew that Geithner failed as a regulator because he never tried to regulate effectively.  Indeed, he infamously testified before Congress: “I have never been a regulator.”  That was true, but you are not supposed to admit it openly and you are not supposed to be promoted to Treasury Secretary because you admit it.  President Obama appointed Tarullo contemporaneously with his appointment of Geithner.  Tarullo had no experience or expertise in regulation and Obama obviously did not choose him to serve as a “feared and hated” regulator.

4.) The idea that Wall Street “feared and hated” Tarullo is hilarious. I can tell you from personal experience what happens when a financial regulator is “hated and feared” by sleazy CEOs because you are putting them in prison and “removing and prohibiting” them from working in finance.  First, there are recurrent efforts to fire you.  Second, they hire private detectives to investigate you.  Third, they sue you for hundreds of millions of dollars.  Fourth, they spend hundreds of thousands of dollars in political contributions to the most powerful members of Congress to induce them to investigate and attack you relentlessly.  Sleazy CEOs did each of these things to me and to several of my colleagues.  Sleazy Wall Street CEOs did none of these things to Tarullo because he never even tried to imprison or “remove and prohibit” them.

Cohan tellingly writes that the NY Fed president “understandably” was the top regulator of the Wall Street banks prior to 2009.  It is understandable in one, sick sense.  It is “understandable” that politicians who benefit so greatly from Wall Street contributions and the revolving door placed the primary regulator of Wall Street banks in the institution (the NY Fed) with the most perverse incentives that would ensure pervasively pathetic regulation of Wall Street banks decade after decade.  It is not, however, “understandable” that anyone seeking to create a system of effective regulation of Wall Street banks would choose the president of the NY Fed to lead the regulation of Wall Street banks.

Cohan’s primary purpose in his column is to present Tarullo’s admissions about what went wrong with Dodd-Frank.

First, he acknowledged that the Dodd-Frank Act, which re-regulated Wall Street at length (and to a fault) in 2010, was a compromise among those lawmakers who wanted to break up the big banks in the wake of the financial crisis and those who wanted to leave the status quo in place.

He said Dodd-Frank “forgoes structural solutions” — such as breaking up the banks or reimposing the separation of investment and commercial banking — “which might have been cleaner conceptually, but much more complicated as a practical matter.”

Instead, he said, Dodd-Frank “imposes a host of restrictions and requirements” on banks, including on counterparty credit limits, risk retention rules, incentive compensation restraints and wind-up resolution planning, while also requiring big banks to increase their capital and reduce their leverage.

***

His most unexpected statement, though, was to acknowledge that the Volcker Rule, named after Paul A. Volcker, the former Fed chairman, was a mistake. The Volcker Rule essentially seeks to prevent big banks from engaging in proprietary trading.

Mr. Tarullo said that when Mr. Volcker proposed it, he thought it could add to the “safety and soundness of large financial firms.” But now, “several years of experience have convinced me” that as drafted, it “is too complicated” and consumes “too many supervisory, as well as bank, resources.”

Here is what Tarullo actually admitted about Dodd-Frank’s fatal flaw.  President Obama and Congress did not frame it as a coherent response to the perverse incentives that cause our recurrent, intensifying financial crises.  Wall Street CEOs rigged our structures to institutionalize perverse incentives.  Refusing to change those structures after a catastrophe was, of course, significantly insane.  President Obama and Congress failed to engage in a rigorous, honest investigation of those structural causes and then refused to fix the structural defects.

The structures that institutionalize perverse incentives have in common the creation of conflicts of interest.  CEOs do this primarily by creating perverse compensation systems, but they also do it through combining investment and commercial banking.  Systemically dangerous institutions (SDIs) (“too big to fail”) create another conflict of interest.  Politicians dependent on their contributions and pathetic regulators treat them as untouchable.  Astonishingly, Obama and Congress refused to fix any of these three primary conflicts of interest that drive our recurrent crises.

The closest Dodd-Frank came to a structural change to address one of these fundamental, destructive conflicts of interest was the Volcker rule.  This makes Tarullo’s repudiation of that rule, and his stated basis for that repudiation so revealing.  Tarullo fears that “as drafted, it ‘is too complicated.’”  Who “drafted” the overly complicated rule – and at who sought to make it so complex?  The answer to the first part of the question is largely Tarullo and the answer to the second part is the five largest Wall Street banks’ lawyers.  Tarullo’s reason for opposing the Volcker rule is pathetic.  Still, the first-best solution is the return of Glass-Steagall rather than the roughly fifth-best solution that is the Volcker rule.  It is altogether fitting that Tarullo leaves with a whimper about a problem of “complexity” that he largely allowed Wall Street to create.

Here is the terrible news.  Tarullo is not remotely evil.  Compared to other senior financial regulators he is in the peak of the distribution along with Janet Yellen.  President Trump’s regulatory appointees will be far worse and by repealing the best parts of Dodd-Frank they will make the next financial crisis far worse.

 

6 Responses to Dodd-Frank Was Designed to Fail – and Trump Will Make it Worse

  1. Thank you, Mr Black.
    Would it be possible to look at euro-zone “zero-bound” negative rates and the choices and/or plauseable aftereffects of this “financial stabilizing”.

  2. Tonight, I watched three men debating on weather to purchase a small wilted over cooked, overpriced chicken, sitting two days under a heat lamp, to divide among themselves. I know about the old chicken since I saw the same chicken sitting there all day on Sunday the day before. These men were weak but only in fear of going hungry. These pussy regulators must live in fear of their own shadows since they never have to face those who are truly weak.

  3. It’s not fair that Wall Street so completely dominates large segments of the market: whether it be financial services, homes, even credit cards and car loans are heavily controlled by the larger banks in this country. There’s a lot more to read at http://www.democraticcapitalism.com

  4. Professor Black: The following is a little off topic, but it concerns me greatly and may concern others, as well… I have been reviewing the work of some of the major U.S. NGOs that include financial reform as part of their mission (or their entire mission) and I came across this statement that seemed likely to be inaccurate: “Earlier this fall [2010?], in a move cheered by retail and institutional investors, the SEC voted to begin long-delayed implementation of post-Enron accounting reforms at companies with under $75 million in market capitalization. Specifically, the Commission voted to require these companies to begin complying next year with the requirement that their independent auditor include in the annual financial statement audit an evaluation of the company’s controls to prevent accounting fraud and errors. The requirement is particularly important to protect investors in small companies, since these companies are more prone to both accounting fraud and financial reporting errors than larger companies and since, when fraud occurs at these companies, it almost always involves the complicity of senior management.” Now there are several reasons why this concerns me… This is an excerpt from a somewhat lengthy analysis of the Dodd-Frank bill (that I think was still in committee in Congress when this document was published) and this is, I believe, the only reference to accounting fraud in the document, which implies that TBTF banks are not as much of a risk with regard to accounting fraud as compared to small companies. What concerns me most about this is the source, which is one of the leading NGOs on the issue of financial reform. I would love to hear your comments on this, Professor Black.

  5. Professor Black: With regard to my original comment earlier today, would you be interested in supporting in some way and/or participating in an effort to compel two of the non-profits, to which I was referring in my earlier comment, to publicly acknowledge the dangers of accounting control frauds within the SDIs and the urgent need to reestablish the criminal referral processes in the appropriate agencies (as well as the need for several of the other reform components in the BWU 60-Day Plan)? I would like to know if you or any of the other BWU members have reached out to these two non-profits in the past asking for their support of the 60-Day Plan and what was the outcome of that outreach (I can email you the names of these non-profits, if you wish). I would think that recognition of this reform by these organizations would be valuable to both your efforts and mine. FYI, I have just initiated a political-action campaign in California (with plans to expand it nationally) that is presenting the 60-Day Plan as an example of the federal financial reform that the White House should be immediately initiating. Thank you, Professor Black.

  6. Sorry this is actually a question about your Kenneth Arrow post, but I can’t find an email to just mail to, is there a cite for his impossibility theorem what paper is it published in?, a google produces many links of people talking about it but nothing obviously the original paper.