June 3, 2015

It's Not Glamorous, but a Very Necessary Financial Reform

Hester Peirce

Former Senior Research Fellow
Summary

Congress is marking the five-year anniversary of Dodd-Frank with legislative efforts in the financial regulatory arena. Improvements to regulatory process are one component of these initiatives. Procedural reforms are not very glamorous, but they are essential in the pursuit of effective regulatory oversight of the financial industry.

Contact us
To speak with a scholar or learn more on this topic, visit our contact page.

Congress is marking the five-year anniversary of Dodd-Frank with legislative efforts in the financial regulatory arena. Improvements to regulatory process are one component of these initiatives. Procedural reforms are not very glamorous, but they are essential in the pursuit of effective regulatory oversight of the financial industry.

The Senate Banking Committee met last month to consider a multi-pronged draft financial reform bill. Much of the bill is a laundry list of technical corrections to Dodd-Frank. Fixing these myriad little flaws is an important step toward admitting that Dodd-Frank is no exception to the rule that 800-plus-page statutes are bound to contain imperfections. 

The more substantive provisions include changes to the way financial companies are deemed to be systemic. Systemic designations, which carry with them an extra layer of regulation, imply a governmental interest in keeping designated firms alive. Designations signal that a future taxpayer bailout is a real possibility. The draft bill's procedural reforms do not eliminate this signaling problem, but they diminish the signal's strength.

A new designation process for bank holding companies between $50 and $500 billion would replace the current automatic systemic classification of these large bank holding companies. This change would allow regulators to take a more careful designation approach that looks at factors in addition to a bank's size. The new process could indirectly improve the nonbank designation process, which has tended to focus unduly on a financial institution's size.

In designating banks and non-banks, the Council would have to explain the reasons for its proposed designations. Companies under consideration could respond and offer a plan for becoming non-systemic. The result would be that companies would have a clearer understanding of why the FSOC thinks they are systemic and hence what they can do to be less so. Offering companies concrete ways to avoid designation would help to reduce the number of systemic institutions, which would serve a worthy Dodd-Frank objective-ending too-big-to-fail.

The draft bill also would require the Council to revisit its systemic determinations periodically. This change would make it harder for designated firms to advertise themselves as being safer than their undesignated competitors. At any time, a company could lose its designation and the implicit government backstop that arguably comes with it. The temporary nature of the designation would prevent the rise of a permanent class of systemic institutions.

Procedural reforms also feature prominently in the Commodity Futures Trading Commission reauthorization bill that came out of the House Agriculture Committee last month. That bill, responding to the CFTC's messy Dodd-Frank implementation process, requires the CFTC to clean up its procedural act. The CFTC, which has resisted careful consideration of the consequences of its Dodd-Frank rules, would have to conduct economic analysis in a manner that more closely tracks the best practices followed by other agencies.

The bill targets another bad procedural habit of the CFTC-its tendency to use informal staff letters to the industry and other non-rules to supplement and amend Commission rules. The bill would preclude the CFTC from rewriting rules through the use of staff letters written without Commission input and would require the CFTC to seek public input on documents that impose requirements on regulated entities.

Both the Senate Banking bill and the House Agriculture bill take aim at parts of Dodd-Frank that have prevented companies, individuals, and regulators from engaging in legitimate and desirable activities. For example, both bills would remove one of the most notorious Dodd-Frank provisions-an insurmountable procedural roadblock to information sharing among derivatives regulators.

Especially when clothed in dry, legislative language, process is hardly scintillating. But it is hard for government to regulate well unless it follows sound regulatory procedures. There is a lot of disagreement about how well the current set of financial regulations works, but people on all sides of that argument can rally around procedural reforms that are designed to strengthen regulatory decision-making.