Drawn Up In the Dark of Night, Dodd-Frank's Unintended Consequences
When Dodd-Frank became law more than four years ago, even its proponents acknowledged that the law needed some tweaks. After all, remaking the financial markets in the wee hours of the night fueled by cold pizza and too much caffeine is a risky undertaking. Despite acknowledged problems, the law has remained largely untouched until this month. Fixes look like capitulation to Wall Street.
When Dodd-Frank became law more than four years ago, even its proponents acknowledged that the law needed some tweaks. After all, remaking the financial markets in the wee hours of the night fueled by cold pizza and too much caffeine is a risky undertaking. Despite acknowledged problems, the law has remained largely untouched until this month. Fixes look like capitulation to Wall Street. It took emergences unrelated to Dodd-Frank-the need to get a spending bill done and the impending expiration of the Terrorism Risk Insurance Act-to drive changes in recent weeks. Concern that fixing errors will help financial firms can overshadow the cost that such errors can impose on the companies and individuals that buy useful products and services from those firms.
On July 15, 2010, shortly after the congressional conference committee finalized the text of Dodd-Frank (but before the president signed it), a number of senators gathered on the Senate floor to point out some problems in the freshly minted Dodd-Frank Act. In so doing, the senators, some of whom had played an important role in drafting Dodd-Frank, acknowledged that the language of the financial reform bill was imperfect.
Sen. Susan Collins (R-Maine) took to the floor to warn that an amendment she had championed could cause trouble for insurance companies designated systemically important by the Financial Stability Oversight Council. Sen. Christopher Dodd (D-Conn.) agreed that size alone is not enough to warrant designating a large insurance company. The FSOC, apparently unmoved by this colloquy, set about designating large insurance companies. The Fed, which is charged with imposing the Collins amendment, pointed out to Congress that Dodd-Frank did not allow it to modify the Collins Amendment to work for nonbanks. Only this month, as FSOC's designation hammer is poised to fall carelessly on another large insurance company, did Congress pass a "clarification" of the Collins Amendment to allow tailoring for insurance companies.
Another Dodd-Frank provision discussed on the Senate floor that summer day in 2010-the so-called swaps push-out rule-forced banking entities to move their derivatives business out of their insured depositories. The reasonable justification was that banks should not be able to use their access to federal guarantees, deposit insurance, and other federal backing to woo derivatives customers. The swaps push-out provision excepted many derivatives transactions, including those undertaken to manage the insured unit's own risks. However, in the words of former Sen. Blanche Lincoln (D-Ark.)-the provision's author, "in the rush to complete the conference, there was a significant oversight made," and branches of foreign banks would not be able to avail themselves of these exceptions.
The omnibus spending bill fixed that "significant oversight." The Fed had already cobbled together a fix of its own, but statutory problems can't be healed by regulation. The omnibus also broadened the swap push-out exceptions to include a broader array of derivatives, including commodity derivatives. This expansion was not necessary to solve the drafting problem highlighted by Senator Lincoln in 2010. However, as professor Craig Pirrong observed, without the change, the push-out provision disadvantages commodity derivatives and consequently harms "the firms in the real economy that use commodity derivatives to hedge their price risks."
The discussion on July 15, 2010 also included another Dodd-Frank trouble spot of greater importance to end users of derivatives. End users are the nonfinancial companies and farmers that use derivatives to manage their everyday business risks. In the pre-Dodd-Frank days, these companies could craft highly tailored derivatives with dealer banks. In these arrangements, dealers did not typically require end users to make cash margin payments to secure the deal. Farmers and Main Street companies are unlikely to have a lot of cash on hand to post as margin, so dealers secure the deal using other less liquid assets.
Dodd-Frank seems to direct the regulators to require dealers to start collecting cash margin from end users. Sens. Dodd and Lincoln, in their conversation on the Senate floor, denied that this was their intent. Sen. Dodd insisted that "there is no authority to set margin on end users." There were subsequent legislative attempts to true the statutory language up with this intent. In one such effort, the House of Representatives voted 411 to 12 in favor of the change. The Terrorism Risk Insurance Program reauthorization bill that passed the House last week and is awaiting a Senate vote contains the same fix. There was some discomfort about including even a technical Dodd-Frank fix in the terrorism insurance bill because; as Congresswoman Carolyn Maloney (D-N.Y.) correctly noted, "Where there are any changes to Dodd-Frank, many Senators take exception. It is very difficult to pass them."
Rep. Maloney is correct in her observation; Dodd-Frank has Teflon-like qualities. It is important to remember, however, that large portions of the statute were drawn up in the dark of night by sleep-deprived minds that had little time to game out the real consequences of the language being drafted. Even those who agree in broad strokes with the philosophy behind Dodd-Frank ought to carefully consider whether it is working as intended and who is bearing its consequences.