Key implications of the Dodd-Frank Act for independent regulatory agencies.

• Author: Seligman, Joel
• Position: Tyrell Williams Lecture

The enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (1) both transcends and transforms financial regulation. The immediate setting of the law is by now a familiar one. By 2008, there was an urgent need for a fundamental restructuring of federal financial regulation, primarily based on three overlapping causes. First, an ongoing economic emergency initially rooted in our housing and credit markets, which has been succeeded by the collapse of several leading investment and commercial banks and insurance companies, dramatic deterioration of our stock market indices, and a rapidly deepening recession. (2) Second, serious breakdowns in the enforcement and fraud deterrence missions of federal financial regulation, as illustrated by matters involving Bear Stearns and the other four then independent investment banks subject to the SEC's former Consolidated Supervised Entities program, (3) led to the government creation of conservatorships for Fannie Mae and Freddie Mac (4) and the Bernard Madoff case. (5) Third, a misalignment between federal financial regulation firms and intermediaries. The structure of financial regulation that was developed during the 1930s did not keep pace with fundamental changes in finance.

* In the New Deal period, most finance was atomized into separate investment banking, commercial banking, or insurance firms. By 2008 finance was dominated by financial holding companies, which operated in each of these types of firms and cognate areas such as commodities.

* In the New Deal period, the challenge of regulating finance was domestic. By 2008, when credit markets were increasingly reliant on trades originating from abroad, the fundamental challenge was increasingly international: major financial institutions traded simultaneously throughout the world and information technology made international money transfers virtually instantaneous. * In 1930, approximately 1.5 percent of the American public directly owned stock listed on the New York Stock Exchange. (6) A report estimated that in the first quarter of 2008, approximately 47 percent of U.S. households owned equities or bonds. (7) A dramatic deterioration in stock prices affected the retirement plans and the livelihood of millions of Americans.

* In the New Deal period, the choice of financial investments was largely limited to stocks, debt, and bank accounts. By 2008 we lived in an age of complex derivative instruments, some of which experience had shown were not well understood by investors and on some occasions by issuers or counterparties.

* Most significantly, our system of finance was more fragile than earlier believed. The web of interdependency that was the hallmark of sophisticated trading meant that when a major firm such as Lehman Brothers went bankrupt, cascading impacts had powerful effects on the entire economy.

The primary enduring response to the 2008-2009 financial meltdown was the enactment of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act is long--the statutory material in H.R. 111-517, the Conference Report that included the final bill, is approximately 845 pages. But the length is explicable given there are sixteen titles addressing fundamental aspects of bank and bank holding company securities, commodities, and mortgage regulation, with detailed new material on orderly liquidation authority, creation of a new Bureau of Consumer Financial Protection, regulation of such previously unregulated areas as investment advisers to hedge funds and OTC derivatives, significant strengthening of payment clearance and settlement, investor protection, credit rating agencies, asset-backed securities, corporate governance, and the Public Company Accounting Oversight Board.

As with the 2008-2009 financial crisis itself, the regulatory response was systemic rather than solely focused on specific financial sectors such as securities regulation or banking. Notably, the Dodd-Frank Act attempts to reduce systemic risk to the United States economy by establishing the Financial Stability Oversight Council, which includes members from the Department of the Treasury, the Federal Reserve Board, the Comptroller of the Currency, the newly created Bureau of Consumer Financial Protection, the SEC, the FDIC, CFTC, the Federal Housing Funding Agency, and the National Credit Union Administration Board. The Act grants the Council authority to require new capital, liquidity, and risk management standards for banks and nonbank financial companies. (8)

The Dodd-Frank Act directly addresses perceived critical gaps or omissions in financial regulation by extending SEC jurisdiction to investment advisers to hedge funds and other private equity funds, (9) authorizing the CFTC and SEC to regulate OTC derivatives, (10) and enhancing SEC authority to regulate credit rating agencies. (11) The enactment of the Dodd-Frank Act ushers in a new period in United States financial regulation in which the regulatory departments and agencies will be less independent of each other, the White House, and Congress. By emphasizing financial stability and risk reduction as paramount goals, the new legislation stresses the need for regulatory coordination, virtual elimination of gaps and omissions, and sufficient regulatory tools to optimize early warning and prompt response to a burgeoning crisis.

But the new general approaches to financial regulation largely build on the structure of the old financial regulatory agencies. The Dodd-Frank Act strengthens the SEC, the CFTC, the Department of the Treasury, the Office of the Comptroller of the Currency, and especially the Federal Reserve System and FDIC. Indeed, much of the lengthy text of the Act appears to have been written by the staff of these agencies and departments. Only one agency--the late unlamented Office of Thrift Supervision--has been abolished. Only one new agency--the Bureau of Consumer Financial Protection--has been established, although within existing agencies and departments, there are a plethora of new required offices, as well as broadened jurisdiction.

This, then, is the paradox of the new financial order: Since the stock market crash of 1929-1933, no set of financial regulators was so incompetent in predicting a financial catastrophe, so slow in response, so rigid in regulatory approach, so inadequate in enforcing existing law as the regulators in charge during the 2008 crisis. Yet the principal winners in the Dodd-Frank Act are the very same set of financial regulators who so spectacularly failed.

How is it possible to enact more powers for regulators who had previously failed? One answer is that the financial meltdown of 2008 and 2009 was a failure of leadership, not a failure of law. There is some truth to this. The abysmal performance of executive branch and Congressional leadership has been the subject of much harsh comment. This criticism reached an apogee in September 2008 when presidential candidate John McCain called for the firing of SEC Chair Christopher Cox, explaining in part, "Mismanagement and greed became the operating standard while regulators were asleep at the switch." (12) In that instance, I agreed with the Wall Street Journal that this assault was "false and deeply unfair." (13)

While Cox's performance will do little to commend itself to financial historians, to single him out and ignore much broader causes for the financial dysfunction is neither accurate nor fair. Let me suggest a more nuanced view that explains more fully why matters went so terribly wrong and why the Dodd-Frank Act is a constructive step forward. In the spirit of the best work of the SEC, let us go back to Genesis and pose the Talmudic question: Why regulate finance?

The basic answer is that we do not always trust financial markets to either avoid financial meltdowns, or to achieve non-fraudulent and acceptable outcomes for investors and consumers. Our methods for achieving this objective largely have been shaped by a history of episodic financial crises. The Federal Reserve System, for example, was established in 1913 as a response to the Financial Panic of 1907. (14) The state securities law system was popularized by fraud in Kansas circa 1911. (15) The New Deal's six federal securities laws were a response to the 1929-1933 stock market crash. (16)

Episodic, specialized financial legislation has the virtue of employing focused responses to immediate problems. Hence, federal banking regulation addressed the safety and solvency of depository institutions as a means to reduce banks runs; the Securities Acts of 1933 and 1934 emphasized disclosure to investors and antifraud enforcement as key mechanisms to restore confidence in securities markets. Congress also emphasized regulatory agencies as the key enforcement mechanism of its 20th century financial regulatory order with the explicit hope that the regulatory agencies would bring the virtues of expertise and dynamic rulemaking to address new problems as they evolved. That system failed early in the 21st century for many reasons, but I want to emphasize three. Part I will address a failure of objectives. Part II will address a failure of structure. Finally, Part III will address a failure of resources.

1. The New Objective of Financial Regulation

   The Dodd-Frank Act is most transformative in changing the basic objective of federal financial regulation from agency-specific purposes to an overarching objective of reducing systemic risk.

   Title I of the Act establishes the Financial Stability Oversight Council (17) and charges the Council in [section]112(a)(1) of Dodd-Frank:

   (A) to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace;

   (B) to promote market...