Last year, in response to the violent market meltdown of 2008 and 2009, Congress passed what is perhaps the biggest piece of financial services reform legislation since the Great Depression. At some 2,300 pages in length, the Dodd-Frank Wall Street Reform and Consumer Protection Act touches on almost every segment of the financial services industry, and it will have far-reaching implications for the country's banks, brokerages and investors for decades to come. But does it do the job it set out to do?
David Skeel, professor of corporate law at the University of Pennsylvania, bankruptcy specialist, and author of The New Financial Deal: Understanding the Dodd-Frank Act And Its (Unintended) Consequences, says, mostly, no. In the book, he argues that, with the exception of the Consumer Financial Protection Bureau, it fails to deliver on its main aims: limiting the risks of contemporary finance — in particular, derivatives — and limiting the damage that could be caused by the failure of a large financial institution.
In particular, when it comes to too-big-to-fail, Skeel says the legislation replaces a good system — bankruptcy — with a new one that essentially institutionalizes the bailouts of the 2008-2009 crisis under a different name: “orderly liquidation.” In all, Dodd-Frank is likely to make American finance more politically charged and less vibrant “than ever before in American financial history,” he writes. We spoke with Skeel about his book, bankruptcy, bailouts and regulation.
Registered Rep.: In your book, you blast Dodd-Frank for encouraging so-called corporatism, or partnership between banks and the government, and ad hoc intervention. What are some historical examples of this, and what are the risks?
David Skeel: Well, the biggie that people can point to, that was actually seen as a success, was the rescue of Long-Term Capital Management in 1998, which was basically coordinated by regulators. But there have been scattered occasions where the government has leaned on either the financial industry, or other industries, particularly during wartime.
What concerns me about Dodd-Frank is it's kind of wired into the legislation. The legislation singles out the biggest institutions, and it gives regulators a series of levers that can be used for a variety of things, one of which is to pressure them and to effectuate political policy. The best evidence that I've seen suggests that there is a cost in terms of economic growth from corporatism, and it's likely to kill innovation and the competitiveness of the markets.
RR.: In the book, you write that the Lehman myth — the idea that Lehman's bankruptcy set the whole financial crisis into motion, which has been used to justify the new resolution authority for too-big-to-fail institutions under Dodd-Frank — is incredibly persistent even though it does not reflect reality. Why do you think that is?
DS: I think there are a few reasons. One is that Lehman was the only institution that was allowed to file for bankruptcy; it was not bailed out. And, at that time, everything seemed to fall apart. There is a natural inclination to attribute that to the bankruptcy, you know, to say that this is what happens when you use bankruptcy rather than bailing out these institutions.
As I talk about in the book, that's really misleading because what really made the bankruptcy such a surprise was that nobody was expecting the regulators to let Lehman go. And so Lehman did not prepare for bankruptcy.
It also was the case that the people who were the architects of the response to the crisis had a pretty strong incentive to say, “Oh, it wasn't us. It was this awful bankruptcy.” Lehman kind of made them look bad.
RR.: Why didn't bankruptcy work for Bear Stearns?
DS: A part of it was that none of the key players, when Bear Stearns was in trouble, had any real bankruptcy expertise. There was nobody in the middle and high levels of the Treasury or the Fed who knew much of anything about bankruptcy. Bankruptcy just wasn't really in their toolkit. It's something that worried me from the beginning to the end about Tim Geithner in particular. He's a really smart guy, but he has a particular worldview, and a worldview that was shaped when we bailed out Mexico in the 1990s and later Long-Term Capital Management. That was his toolkit and that's the toolkit that got used.
RR.: Don't banks and other financial institutions almost invariably find ways around regulation? Is there a way to craft regulation to prevent this?
DS: The answer is yes, they do. If you do have a regulation that is probably going to be evadable then you need to be very realistic about its prospects. And for me, the great example of that in the legislation is the Volcker rule. I've actually been surprised that it has seemed to have as much tape as it has. You know, Goldman and others had sold off some of their proprietary trading. But, I think, in the long run, commercial banks that want to get around it, will.
It does suggest that an approach that attempts to micromanage what banks are doing is probably not a promising approach. And that's one reason why the kind of regulation I argue for most strongly in the book are things that it is in these institutions' own interest to invoke. If you make some changes to our bankruptcy laws, if an institution like a Bear Stearns is in big trouble, it would create a reason for them to file for bankruptcy rather than waiting for regulators. It's not perfect, and it won't end up working all the time, but it does strike me as making bailouts a little less necessary, making it a little less necessary to depend on regulators, and being a little less susceptible to evasion.
RR.: You mention in the book that there was a brief period, during the New Deal, when the expertise of regulators matched that of industry. Is that repeatable?
DS: During that period, some of the top academics in particular went to Washington, and worked for the SEC, and worked for the other agencies. But they didn't sustain that over time. So, is it just inevitable that you're gonna have this gap between regulators and Wall Street? I think the short answer is, yes. I mean, unless you can somehow pay regulators Wall Street salaries.
But in light of that reality, you can try to make the regulatory jobs as attractive as possible. The other thing that I think you want to do is try to steer clear of regulations that require you to be smarter than Wall Street. You know, sometimes what looks like a brilliant regulation just won't be effective because of a sophistication gap.