The Regulatory Intervention That Took Place in the US Post 2008 Crisis - Assignment Example

? Table of Contents 2 Introduction 3 Causes of the 2008 Crisis 4 Dodd – Frank Act 5 Advance Warning System 6 Too Big to Fail Bailout 7 Dichotomy: Big Brother versus Invisible Hand 8 International Perspective: G20 10 Japan 10 Germany 11 Recommendations and Lessons Learned 12 Conclusion 13 References 14 Abstract Consequences of the 2008 crisis were enormous. Most important and largest mortgage lenders such as Countrywide were bankrupt. The Dodd – Frank Act was enacted on 21 July 2010 by the President Obama. There are advantages and disadvantages to the Act. Though this act addresses the causes of the crisis, such as the interconnectedness of large financial institutions and the spread of the failure of one on others, problems are created as well. There is a dichotomy between investor protection on one hand, and the need to have a government that does not interfere too much with the economy. The President Obama ended the era of investor protection enacted by President Roosevelt. As a result, uncertainty in the markets is created. Moreover, international companies bear the brunt of their presence in the United States. However, this act focuses more on systemic risk than its equivalents in other countries, such as Japan and Germany. As a result, the United States complies more rigidly with some of the G20 recommendations than other countries. Introduction Until 2007, the world experienced low inflation levels, high growth and an increase in international trade and movements of capital.1 Then in 2007, the housing markets started to collapse, as lenders began to default on their mortgages. However, soon defaults spread across other parts of the financial industry and in 2008, the United States entered a crisis whose consequences are still felt today. The crisis spread globally, as many foreign banks invested in the American financial industry. 2 Consequences of the crisis were enormous. Most important and largest mortgage lenders such as Countrywide, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and American International Group (AIG) were bankrupt. 3 The nature of the crisis is such that a chain of reactions in the housing markets led to a failure of many financial institutions. Thus, the spread of the crisis is indicative of the causes of the crisis being in the housing market and the ability of the housing market collapse to spread to other markets, and eventually affect the real economy as well. In short, due to such interconnectedness, there are multiple explanations of causes of the crisis: over borrowing and securitization of mortgages, inadequate financial regulatory structure and failure to properly foresee possible problems that might arise from recent financial innovations are main causes of the 2008 crisis. Though the Dodd – Frank Act (Act) was passed to address the 2008 crisis and prevent a future crisis of such a magnitude, the Act creates instability on the markets, and fails to address properly the international nature of the crisis, which will be further elaborated on in the paper. Causes of the 2008 Crisis As Reinhart and Rogoff put it, there was a lull in defaults, globally and domestically, before the 2008 crisis took place.4 However, the two authors note that the last lull was the deepest in the last two centuries of the American history. 5 The regulators created a weak regulatory system. Between 1990 and 2006, housing prices increased to an average of four times the yearly income of an average family two or three times previously.6 High housing prices led to high demand for construction workers, remodelling and real estate services. Moreover, the repeal of the Glass-Steagall Act in 1999 enabled banks to engage in investment banking, while banks could also act as insurers. Mortgage – backed securities were invented and sold freely. 7 In 2000, the Commodity Futures Modernization Act deregulated the derivatives market, which was used by banks to increase liquidity. 8 Risky homeowners were encouraged by the Clinton administration to acquire expensive homes, despite their low or unstable incomes. 9 The crisis started unravelling in August 2007. After 2005, the hurricane - damaged economy of the Gulf Coast and the weak Midwest, weakened consumers’ ability to pay off their mortgages.10 Moreover, in Arizona, Florida and Nevada, the so called housing miracles, experienced a steep correction to the housing bubble, which led to further inability to refinance their mortgages, and a decrease in employment of adjacent sectors such as construction.11 However, unlike what was expected, banks became illiquid with too small assets and too large liabilities, affecting financial institutions which suddenly owned valueless securities.12 Laws were inadequate to deal with the crisis. Prior to the crisis, the Treasury’s rule was to focus on risk mitigation and prevention.13 However, the Treasury viewed these innovations with favour, believing that “they added to the liquidity and efficiency of capital markets and made it easier for firms and investors to lay off risk.” 14 The policymakers supported the recklessness of the financial system. Dodd – Frank Act in Short The regulatory interventions took place after 2008. The Dodd – Frank Act was enacted on 21 July 2010 by the President Obama.15 The legislation aimed to eliminate bailouts. 16 President Obama ended the era of investor protection enacted by President Roosevelt. 17 The Dodd – Frank Act has two main objectives: “Its first objective is to limit the risk of contemporary finance—what critics often call the shadow banking system; and the second is to limit the damage caused by the failure of a large financial institution.” 18 The Dodd – Frank Act is more stringent in control of capital than the previous regulations.19 The authority controlling the agencies created by the Act is the Financial Stability Oversight Council. 20 This Act affects several agents and instruments in the American economy: banks by eliminating their previous right to proprietary trading under the Volcker rule, derivatives which must be sold through a clearing house, insurance companies which are now controlled for risks they produce, rating agencies which can now be de – certified for fraud, consumers which could previously engage in risky lending, and whistleblowers who report risky activities.21 Its main objectives are focused on two areas. 22 The first objective deals with limiting the financial risk, which led to the 2008 crisis. Another objective deals with bailouts, trying to restrain financial institutions from moral hazard, which arises when institutions engage in reckless behaviour because they know the government will bail them out. Advance Warning System The first objective attempts to identify and eliminate risky institutions, which could cause another adverse chain of events.23 This objective focuses on derivatives. It was derivatives that led to the creation of mortgage based securities. Before the crisis, mortgage-backed securities and credit default swaps (CDSs) were developed and widely used. A mortgage-backed security is a pool of mortgages that were bundled together and sold as securities.24 In order to control them, a clearing house was set up under the name of Securities and Exchange Commission (SEC), which would protect investors from failed derivatives. The same institution would also increase transparency and regulation of financial institutions.25 SEC has the authority to require shareholders to be included in nominations for a position of a director. 26 Office of Financial Research (OFR) is in charge of collecting data on possible risky institutions and future crises.27 Moreover, pension funds and investment companies are required to buy securities only certified by credit rating agencies.28 However, McKinley argues that such a system was already in place.29 According to McKinley, such an entity existed in the 1980’s, but of a much smaller size. This, however, is too large and thus easy to wind up in lack of coordination and red tape. An example is bankruptcy of MF Global, which filed for a bankruptcy on 11 October 2011. However, OFR failed to predict, or in any way prevent this event. 30 As a result, this objective of the Act has been unsuccessful so far. Information gathering on firms is an ambitious task. Too Big to Fail Bailout The second objective is to end bailouts of too big to fail institutions from 2008. 31 This part attempts to transfer costs of such companies to shareholders instead of taxpayers.32 This is achieved through the Federal Deposit Insurance Corporation (FDIC). In case of a need for a bailout, a financial institution is authorized to file a petition in federal court in Washington, appointing FDIC. The latter then takes over the institution and liquidates it, as it has historically done with commercial banks. 33 Eight institutions are guarded. Eight institutions have been branded as systematically important financial institutions (SIFI) under this objective.34 These companies are subject to stress tests and stricter leverage limits and risk – based capital requirements. In case some file for bankruptcy, FDIC would step in. However, FDIC is incompetent in case of international institutions due to international interconnectedness. In case an international institution needs to be liquidated, other countries will freeze their assets in order to protect their investors, leaving FDIC powerless. 35 Moreover, the Act requires foreign financial institutions to comply with the Act. This requirement implies that foreign institutions will have to change their operational procedures.36 The requirement also includes that the foreign institutions provide the United States government with information on its foreign operations, as well as their connection to the institution’s operation in the United States. 37 Though such a requirement ensures that foreign institutions engage in prudent investments abroad and in the United States, access to their confidential information could be abused by the United States officials and their constituents. However, the Act does not coordinate with the international community to smoothen the compliance of international companies with the Act.38 Without international cooperation, systemic risk cannot be eliminated. Systemic risk decrease would ensure that crisis does not spread across the entire economy. 39 However, so far this is just a goal, as the tools at FDIC’s disposal have not been perfected. Dichotomy: Big Brother versus Invisible Hand There is a dichotomy in the way the Act is applied, especially with regard to the second objective. According to Skeel, two important mishandlings of the Act emerge in its application, which could result in market distortions. These are: “(1) government partnership with the largest financial institutions and (2) ad hoc intervention by regulators rather than a more predictable, rules-based response to crises.” 40 Markets will be disturbed. Skeel provides an insight into how the government through ad hoc interventions could interfere with the economy. The government could take over a company simply because company trades with a national enemy, regardless of the health of its balance sheet. 41 As a result, companies with political ties would be favoured over those with none, and those trading with the enemy would be eliminated. Since the government focuses on the largest financial institutions, most of the economy through this policy is affected by changes in political climate. Financial institutions will have to act in accordance with national, political interests and perhaps even in an economically imprudent way, simply to cater to the political ideology dominant at that time. Moreover, red tape will choke economic activity. According to Simon, economic activity depends on the amount of regulation, and is inversely related to it. He cites the former Federal Reserve Chairman Alan Greenspan, who argued that 50 to 75 percent of reduction in long term investment can be explained by increased government presence, which reflects itself upon the markets through increased uncertainty.42 The more regulated an economy is, the harder it is for businesses to navigate across all of the rules, especially if, as in case of Dodd – Frank Act, most regulation has still not be implemented. According to Simmonds, firms will spend up to $ 150,000 on implementation of sections 404 and 406 of the Act.43 Institutions will be overwhelmed by the amount of red tape produced, which will increase their costs and decrease their manoeuvring space on the markets in terms of operations and risk taking. Implementation of the Act by the corresponding administrative agencies has not been completed either, which will only add to the costs of adjustment on behalf of firms. 44 Though the government attempts to strengthen the markets, it will disrupt their invisible hand. This act was designed to help strengthen companies and markets, all of which were ruled by the so called invisible hand, i.e. they coordinated resources based on the demand and supply and the resulting market price. However, with this act, there will be a distortion as companies will also be controlled by the government. In turn, companies could experience lost profits because of the government politics. Moreover, favoured companies could remain reckless, which would increase the so called moral hazard.45 Furthermore, the constituents, the American consumers, will not be protected. Instead, they face higher costs on their checking accounts and transactions, which is hardly what the Act attempted to achieve.46 International Perspective: G20 In many respects, the Dodd – Frank Act resembles action taken globally. The most dominant forum in the international community on the current crisis, G20, created several guidelines attempting to prevent a future crisis of the current scope. 47 The Dodd – Frank Act is similar to forum’s decisions as both aim to contain the too large to fail companies, while protecting taxpayer money. Moreover, G20 called for supervision of financial institutions, which is equivalent to the early warning system under the Dodd – Frank Act. Systemic risk is better addressed in the Act. Basel III standards are promoted in both systems, though to the lesser degree in case of the Dodd – Frank Act.48 Germany implemented Basel III rules, but the latter is less efficient at reducing systemic risk. As will be shown, Japan and Germany implemented G20 recommendations more stringently than the Act with regard to banks, but less in case of all financial institutions. However, G20 recommendations address global companies, which is where the Act fails. G20 countries must ensure that global financial institutions under domestic laws are not hindered in any way with regard to their efficiency. 49 As already mentioned, the Act requires foreign institutions to align their operations with the Act, while it does not take into account regulations in other countries. Japan Japanese policies provide more flexibility and coverage of banks than the Dodd – Frank Act. Unlike the United States, the crisis spread to Japan indirectly through a decrease in export demand due to the fact that Japan has a preference for banks instead of financial institutions and the derivatives such as CDCs.50 Japan has been a firm proponent of banks, resulting in control of all financial derivatives, whereas the Title VII of the Act applies only to swaps, options and security – based swaps.51 However, foreign companies can decide which country’s laws to abide by, whereas this is not possible under the Dodd – Frank Act, also indicating that financial sector is not as regulated in Japan. Germany Germany is another example of a country focusing on control of banks primarily. Unlike Japan, Germany has been addressing the too big to fail firms as well. However, the bank tax instead of liquidation has been introduced. 52 Germany is using this tax to fund its Restructuring Fund, which will focus on future financial crises and assist troubled companies. 53 Unlike the Act, German Fund has been operational since 2008.54 German approach is different, as it does not focus on liquidation, but on restructuring. There are benefits to such an approach, as it addresses the problem of too big to fail companies by restraining the spread of their failure to other companies. Since such companies are very large, their balance sheets are connected to other companies through trading. Moreover, companies cannot be nationalized at will, as some critics of the Act have argued. However, the Act provides a better warning system and better attempts to decrease systemic risk. The Act is more diverse, attempting to control banks and non – banks, whereas other G20 countries focus more on banks. 55 Though Japan addresses foreign companies, its policies actually stem from control of the banking sector. Moreover, Basel III rules focus more on individual bank risks than on the industry risk as a whole.56 Germany focuses on Basel III. Thus, though the Dodd – Frank Act has its disadvantages, advantages are also present, as despite all innovations in Germany and flexibility and oversight in Japan, the Act provides a warning system covering more sectors. Recommendations and Lessons Learned Two concerns arise with regard to the Act: bailouts and uncertainty in the markets. In order to decrease uncertainty, the Congress must oversee the agencies created by the Act. According to Simon, “the Constitution requires that Congress still decide the basic policy questions by providing an “intelligible principle” for all enactments. This provides at least some economic certainty for businesses, which could turn to the “intelligible principle” for guidance, knowing that it constrains regulators.” 57 In short, this recommendation argues that businesses will face less uncertainty with regard to regulatory action, and possibility of ad hoc liquidations. Moreover, Germany’s bank tax and restructuring could help decrease uncertainty, while saving taxpayers’ money. Japan’s flexible system for foreign institutions could provide them with options. Bailouts will remain in absence of international cooperation. The Act does not provide for international cooperation, though large financial companies have international operations and thus their problems in one country are usually felt in another as well. 58 Without international coordination, the Act will remain interfering with operations of international companies, affecting FDIC and again, increasing uncertainty with regard to the Act’s ability to end bailouts. However, since most countries, such as Japan and Germany, focus on banks, international cooperation on financial institutions might be harder to achieve. Conclusion The Dodd – Frank Act is an ambitious project. It addresses systemic risk better than G20 countries. Both of its main objectives are better achieved under the Act than internationally. However, in terms of economic efficiency, this act increases moral hazard, which could increase reckless behaviour and again lead to additional systemic risk.59 Thus, a few innovations are necessary, such as increased international cooperation and application of the intelligible principle, which would decrease systemic risk, make FDIC operational and also decrease moral hazard. The International Labour Organization stated that the financial sector’s share of corporate profits increased from 25 percent in 1980 to over 40 percent in 2000’s, but these profits were not returned to the workers and consumers.60 Thus, if Dodd – Frank Act is to succeed, it must finally become fully operational. Else, investors and consumers will continue facing high uncertainty and costs as taxpayers. References 1. Acharya, VV, Cooley, T, Richardson, M and Walter,I 2010, Regulating Wall Street: The Dodd – Frank Act and the New Architecture of Global Finance. Available from < http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/RWS_Presentation.pdf >. [14 November 2012]. 2. Acharya, VV 2012, The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, and Lessons for Emerging Markets, ADBI Working Paper Series. Available from . [11 November 2012]. 3. Avery, AW and Barnard KF 2011, Basel III v. Dodd – Frank: What Does it Mean for US Banks. Law Business Research Ltd. 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Reinhart, CM and Rogoff, KS 2008, ‘This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.’ NBER Working Paper No. 13882, pp.1 - 123. Available at NBER [11 November 2012]. 23. Simmonds, D 2012, Too Big not to Fail, The Economist. Available from . [11 November 2012]. 24. Simon, A 2012, Dodd – Frank at Two: Bad for Business and the Constitution. Available from . [11 November 2012]. 25. Skeel, DA 2010, The New Financial Deal: Understanding the Dodd - Frank Act and its (Unintended) Consequences. Available from . [11 November 2012]. 26. Senate n.d., Brief Summary of the Dodd – Frank Wall Street Reform and the Consumer Protection Act. Available from < http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf >. [11 November 2012]. 27. Swagel, P 2009, “The Financial Crisis: An Inside View.” Brookings Papers on Economic Activity, Vol. 2009, pp.1 – 63. Available from Project Muse [12 November 2012]. 28. Verrett, JW 2012, About The Dodd-Frank Act, George Washington Would Be Turning Over In His Grave. Available from . [11 November 2012]. Read More