Hester Peirce on *Reframing Financial Regulation*

Hester Peirce is a Senior Research Fellow at the Mercatus Center at George Mason University and director of Mercatus’ Financial Markets Working Group. She joins the show to discuss the new Mercatus book, *Reframing Financial Regulation: Enhancing Stability and Protecting Consumers*, which she coedited. The book examines the problems with the United States’ current financial regulation regime (including the Dodd-Frank Act) and offers alternative policies that rely less on a centralized regulation and more on market discipline.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Hester, welcome to the show.

Hester Peirce: Thanks, David, for having me. I'm a big fan, so it's an honor to be here.

Beckworth: Well, you're my colleague and we often talk, and Hester often gives me great feedback on my other podcast show. So it's great to have you on. Let's begin by asking, how did you get into this area, this career path where you look at financial market issues and the regulatory decisions surrounding them?

Peirce: Well, I wish I could say that I had a clear career plan when I started out, but I did have an interest in securities markets from when I was a little kid. I remember tracking them on graph paper. I'd track stocks. I didn't invest, but I'd track them. I would have done really well had I invested, I'm sure. But then when I went to college, I found economics and it really changed the way I looked at the whole world. So I thought of maybe going on in economics and getting a PhD, but ended up going to law school instead. Maybe math had something to do with that. And so, ended up in securities because that was a natural combination of liking to think about economics but also enjoying the law.

Beckworth: How did you get into securities regulation, because you worked for the SEC for a while, right?

Peirce: Yeah, but I started out at a law firm that really specialized... They had a number of specialties but securities was one of them. And so, that's how I got pulled into that. From there, I met people who had worked at the SEC and really recommended that to understand securities law, you needed to go and work at the SEC, and I found that to be true. So I really enjoyed my time at the SEC understanding securities law from the inside.

Beckworth: Okay. Then in 2008 during the crisis, you were in the Senate on the committee with Senator Richard Shelby. Tell us about that experience, particularly working on Dodd-Frank.

Peirce: Yeah, I mean I arrived in August, 2008, so it was a kind of crazy time to get there and a lot of things were happening. And so, during the crisis, it was a very interesting place to be. You were seeing policymakers' reactions, hearing from industry, hearing from people in the markets, what was going on. But then when it came to actually drafting legislation, of course, everyone wanted to do something because we'd had this crisis.

Peirce: It was a rather unpleasant event in many ways, because I saw a lot of things being put into legislation without a lot of thought about what is the problem we're trying to solve here. It was just kind of a knee-jerk reaction, "We need to regulate more," not really knowing what to do. So a lot of discretion was given to regulators. Having been at a regulatory agency, I saw that that might end up being a little bit problematic.

Beckworth: Tell us what Democrats actually said when that bill was passed.

Peirce: Well, I mean, I think everyone acknowledged that it was an imperfect bill. And so, people said, "Don't worry, we'll fix it. Let's just get it passed and then we'll fix it." But now it's 2017 and fixing hasn't happened yet. To me, it was rather discouraging to see people passing something that they knew was broken to start.

Beckworth: It was interesting preparing for the show. I learned that no GOP house member voted for it when it went to the house side, and only three GOP senators voted for it. So it was rushed through, was really supported by one party. The fact that it hasn't been well received and it hasn't been successful as some have hoped, and we'll talk about some of its issues in a minute, shouldn't be surprising, and I guess it isn't surprising now that the Republicans in power, they want to do some changes.

Peirce: Yeah. One other thing to note about a bill like that is, because it's such a huge bill, when something like that is going through and people know it's going to pass, they're throwing all kinds of things onto it because it's their chance. So you saw the agencies coming in with their wishlists. You saw people in industry coming in with their wishlists, and other constituencies coming in. And then, of course, everyone on the Hill had ideas they wanted in there. So lots of things got thrown in that no one thought had anything to do with the crisis. And so, that was also kind of depressing because normally those kinds of things would get a little bit more thought and consideration.

Beckworth: So when these senators and congressmen voted on the bill, many of them had not read the entire bill?

Peirce: Well, I mean, reading legislative language is long and hard and a lot of the language came in at the last minute. So people really hadn't had a chance to consider it. Now, I will say that the folks who were passing this had good intentions. They wanted to stop a financial crisis. And so, good intentions are important, but they're not everything.

Beckworth: Yeah. It's interesting. So the folks who really wanted to have some kind of response, more regulation because of the crisis, and they too had to be mindful that lobbyists would be in there. Like you mentioned, people would be coming in. Big banks would be pushing their angle. And this bill is just as susceptible as any bill to that kind of influence, right?

Peirce: Sure. When you're trying to rush something like this through, you have to rely on people who know the laws very well to give you insights. And so, you're going to be talking to people. But if more time had been taken, some of the problems could have been identified and fixed.

Beckworth: What are some of your main concerns with it?

Problems with Dodd-Frank

Peirce: My main concern is that I don't think it will work. So I think the intention was to make our financial system safer. And I don't actually think it does that. I think it does quite the opposite. The reason I think it won't work is because it has this idea that regulators are going to be the ones to stop a problem. So it basically hands the financial system over to the regulators and says, "Here, you watch this. You identify any problems, and you stop them before they get really bad." And that's an impossible task for regulators.

Peirce: Regulators are people, and they are people without great access to information. So we're asking them to do a task that they're destined to fail out, not because they don't have good intentions and not because they don't work hard. They do. They're hardworking people, but they're just not going to be able to succeed at the task.

Beckworth: It's interesting. Larry Summers had a Brookings paper recently where he made the same point that we really aren't any safer today than we were before. And he comes from the left. And I had Maddie on the show recently. She agreed. She goes, "We're not that much safer, if at all." So it's been how many years now since that bill was passed?

Peirce: It's 2010, so-

Beckworth: 2010. I mean, you're going on seven years and we really aren't that much safer. So we're just as susceptible in some ways to an economic shock. Now some of the complaints I've heard about the bill is, one, it really favors large banks because they have the resources to deal with the compliance costs, the complexity of Dodd-Frank. I visited a small regional bank, a CEO in Tennessee, and he was just mad. All he could talk about how awful Dodd-Frank was because of the compliance cost it was putting on his bank. So is it a fair assessment to say that Dodd-Frank is really putting a damper on small and medium-sized banks?

Peirce: I think that is fair. It is expensive for large banks and very burdensome for large banks. But they have the capacity to handle those kind of compliance issues. The smaller banks really do feel the weight of even having to read through all the rules that are coming out of Dodd-Frank to figure out if you have to comply. It's a big job. And at the smaller banks, it ends up taking a lot of time of the CEO of the bank. Other people who would normally be doing banking are now basically regulatory compliance lawyers. So that's a worry I have. It's distracting people from doing the jobs that they should be doing. And that's a big worry.

Beckworth: Has that really slowed down community banking? I mean, do we see slower growth in community banking?

Peirce: Well, we haven't seen new community banks coming up. The number of new bank charters has been very low. The number of community banks has been dropping for a long time, so it's hard to sometimes figure out how much of that is from regulation. But we did do a survey of small banks after Dodd-Frank, and they had the same reaction as your friend in Tennessee, just really feeling under the weight of this new regulatory burden and feeling really at a competitive disadvantage because of it.

Beckworth: Now, hasn't there been some talk about exempting small banks from some of the requirements.

Peirce: Yeah. And they in Dodd-Frank did exempt small banks from some things. So there were some accommodations made for small banks. And there's been talk about doing more of that. It's just sometimes difficult to figure out how to put that into practice.

Beckworth: Okay. Dodd-Frank hasn't solved "too big to fail". Is that a fair assessment as well?

Peirce: I think that's a fair assessment. Yes.

Beckworth: Okay. And we'll talk about that in a minute. One of the chapters in your book talks about this issue. But that's another complaint I've come across is it affects small-medium banks. It really hasn't solved "too big to fail". Also Fannie and Freddie. Yeah, that's another issue, right?

Peirce: Fannie and Freddie, yes, is a very big issue, really unaddressed by Dodd-Frank. And that's part of the reason they couldn't address it was because they were trying to get everything through so fast. And that's a very politically difficult issue. But certainly one that everyone agrees was central in the crisis. So it's remarkable that it wasn't addressed.

Beckworth: Well, it's remarkable we've come this long and we still haven't addressed them.

Peirce: That's right.

Beckworth: I mean, it's shocking, right? They played a big part or they were at least a propagating mechanism in the crisis. And here we are still, want to know what to do with them. All right, let's move to your book, and you're a co-editor. The book again is named “Reframing Financial Regulation: Enhancing Stability and Protecting Consumers.” Now, you're a co-editor. So tell us about the story behind the book, how many authors you have, sections you have. Tell us about the details of the book.

Reframing Financial Regulation

Peirce: It's a big project in the sense that we pulled together quite a few authors. I don't even know. The final number is 17 chapters, but there's some overlap in authors. After Dodd-Frank, and once I came to Mercatus, one of the things that I thought would be useful is just to have a book that kind of goes through Dodd-Frank and identifies some of the problems in each of its titles. And so, we did a book on what Dodd-Frank is and why it's flawed. And so, a lot of people said to me, "Okay, well, let's talk about some solutions now. And so that's really what this book came out of, to say, "Let's have a discussion about really rethinking how financial regulation works." So that's kind of the Genesis of this book. We want to get a discussion going about thinking a little more creatively about how we might do financial regulation.

Beckworth: And it's broader than just Dodd-Frank?

Peirce: It is broader than Dodd-Frank. Certainly Dodd-Frank comes up a lot, but there is a lot more in it than just Dodd-Frank

Beckworth: For our listeners, they can get an online copy for free, is that right?

Peirce: That's correct, or you can get it at Amazon. But it's on our website.

Beckworth: Yeah. So those interested listeners can go online and download the chapter separately too and-

Peirce: Correct.

Beckworth: Or the whole book. Okay. One last thing about Dodd-Frank maybe, and maybe some of the resistance to maybe this book would be, what is your objective here? Are you trying to roll back Dodd-Frank to the era when there was less regulation? I've often heard that we don't want to go back to the era of no bank regulation, but you can tell that's somewhat of a myth.

Peirce: Yeah. We've had a lot of bank regulation. And even in the lead up to the crisis, people say, "Well, it was a deregulatory time." But if you really look, a colleague of ours, Patrick McLaughlin, has gone back and kind of measured the regulation and shows that there was actually pretty consistent upward trend in regulations. So it's not for lack of regulation that we've had problems. It's because we had the wrong regulation. So, no, I would not want to go back to the status quo before the crisis. We definitely need to rethink financial regulation. And so, I understand why people are hesitant to say, "Roll back Dodd-Frank," because it's really not rolling back. It's really replacing it with something that would work better. That's what we need.

Beckworth: Okay. So the right kind of bank regulation, not no bank regulation.

Peirce: Yeah. I want to think more broadly than just banks too. I think one of the things that's come out of Dodd-Frank is this desire to regulate everything as if it's a bank, and to really tamp down risk-taking. This is a point that that former SEC Commissioner Gallagher makes in his chapter. You can't regulate the securities markets the way you regulate banks because securities markets are about success and failure. And so we have to let institutions fail.

Beckworth: Good point. All right. So the first part of your book looks at regulating loss absorption. This section does a lot with issue of bank capital or equity. So, as many of our listeners probably know, leading up to the crisis, even now, banks were largely funded through debt as opposed to paying for themselves, having their own skin in the game. And so there's been a big push. I mean, many of the guests have come on and talked about this and many observers think banks should fund more through equity, less through debt. And, of course, how do we get there, and then how do we avoid this issue? So what is brought up in the book as the issue and maybe the path forward?

Skin-in-the-Game and Debt Financing

Peirce: Well, I think one of the issues that's really hit on in the book is that risk-based capital, which is the approach that we've taken to date, which is looking at what's a bank's assets are and calibrating its capital depending on what the assets are. And so, that becomes a very complicated exercise. So one of the chapters in the book by Stephen Miller argues we just need to have simpler capital. It needs to be higher, but it also should be simple, not based on risk. Let's just have a straight capital or leverage ratio, essentially.

Beckworth: And right now the reason we don't is because of Basel III, is that right?

Peirce: Right. That's an international agreement that essentially all the regulators have come together and put stuff into different risk buckets. And that's something that Arnold Kling goes through the history in his chapter and talks about how we got to the place we are with the risk buckets.

Beckworth: In my discussion with Annette and Maddie, she brought up how Basel II helped contribute to the crisis because of the risk weighting. I mean, the risk weighting allows you to play at the numbers, and you can put certain assets in there that really allow you to get away with effectively more debt, less true equity. Is that still a concern?

Peirce: Yeah, that's still a concern. It becomes kind of a political game too because if you can get certain government securities, for example, how do you categorize those? Or are they low risk or high risk? And you don't want to offend a country. And so, some changes have been made before the crisis. It was worse than it is now, but still, arguably there are still problems with that.

Beckworth: Okay. Now, I have a question about this because something that I've found attractive, and maybe it's not politically viable. But something I find very interesting and fascinating is this idea of contingent liability for banks as a solution to getting banks to increase their capital holdings. And the way this would work for our listeners is you would make the shareholders liable for all the losses, double liability, triple liability, whatever it would be, you make them liable.

Beckworth: Right now, it's limited liability shareholding for stockholders. So, historically, this was done up until about the time of the Great Depression, if I think I'm right on that. And then after FTSE, it disappeared. So is there any chance we'd ever see that again, and would it work? I mean, is it a viable idea?

Peirce: It's not discussed in the book. I wish that it had been because I do think that it's something that we should consider. It's obviously a big change if we were to go down that road. Yeah. But it would add a measure of discipline, and I think it would be a caution, not everyone would want to hold bank stock if there's extra liability. And it raises issues in the securities world too, how do you mark these stocks as being different? But I definitely think it's a route that we should explore. And maybe in connection with capital requirements, you could work that in. It's not one that I've thought or written a lot about, but it's one that I think is worth pursuing.

Beckworth: Yeah. Because it seems to me the tough question is, how do you get banks to increase capital, number one, and then what's the right number? That seems like just a question that we don't know. It's part of the knowledge problem even maybe. I can invoke Hayek here. And it seems to me that if you incentivize banks themselves to acquire more capital... Acquire is the wrong word, to fund with more capital, they themselves would be able to figure out what's the appropriate amount given the risk of their portfolios.

Peirce: Yeah. I mean, you've hit on something that is a concern of mine. We don't have to tell non-financial companies how much capital... Non-banks, how much capital they have to be funded with. So why are we in this situation where we have to be telling banks how much equity they have to have? Because we have all these other government subsidies for banks, that's kind of why we are where we are.

Beckworth: Yeah. There's a lot of knowledge issues here, right?

Peirce: Yes.

Beckworth: I mean, how to proceed. I mean, we have a system in place that is forcing us to consider these issues, so-

Peirce: But the knowledge issues, I mean, I'm glad you brought that point up because I think that's at the core of what's wrong with Dodd-Frank, is the people who drafted Dodd-Frank didn't read Hayek, and they don't know about the knowledge problems. So they don't realize that knowledge is dispersed. Concentrating it all in one place is really difficult, but they're counting on that, and that's what they're counting on to protect us, is that we've got these very knowledgeable super regulators at the center of everything watching and kind of moving things around when they see a problem. It's not going to work because they can't get that knowledge.

Beckworth: Yeah. They don't have enough understanding of all the different banks and issues going on. It's just too much for a committee or a group of regulators to understand. I'm going to jump ahead then and raise another question, which I don't think is in the book. That is the issue of doing macroprudential regulation. Is that in the book or is that talked about?

Peirce: It's not in the book. I mean, it's something that I've talked about some elsewhere. It's definitely a concern. And so, the idea is that we had microprudential regulation, which is the bank regulators are looking at each institution and making sure that it's safe and sound. But now there's this notion that, no, that's not enough. We need to have macroprudential, which looks at the whole financial system. And then, the regulators can come in and say to a bank or another financial institution, "We know what you're doing is good for you, and safe and sound for you," but we think it's bad for other people. And so, we're going to tell you not to do it.

Peirce: And, one, I mean, that raises the question of how does the regulator know that? And two, it really raises questions about the ability of the bank then to operate on behalf of its shareholders if it's getting this outside message that it has to listen not to its customers, not to its shareholders, it has to listen to the regulators and override them. It makes it very difficult to manage a bank.

Beckworth: This again goes back to the knowledge problem too, right? That the regulators have to know somehow, have omniscience knowing, this is the amount of capital you should be holding, or these are the types of activities you shouldn't be doing.

Peirce: Exactly.

Beckworth: So it seems like a tough calling for regulators to try to do macroprudential regulation. Now, isn't that a part of Dodd-Frank, the Financial Stability Oversight Council?

Peirce: Yeah, it is. The FSOC, as it's known, brings together a group of financial regulators, both Federal and state, and it asks them to pick out the financial institutions that it thinks might be a problem. And those then get shipped over to the Fed for special regulation. So that's very much a macroprudential mission. It's this idea that we can spot systemic risk and we can then deal with it when we see it, and I think it's a fool's errand.

Beckworth: That's part of the stress testing the Fed does then, is to go to these banks and say, "What happens if certain scenarios unfold in the economy?"

Peirce: Right. That's not a bad idea,, for a bank to be doing stress testing. I would hope that these financial institutions are thinking about what might happen down the road and how might this affect us, and then taking steps to prepare for that. That's a normal thing for a bank to do. But when the regulators come in and they say, "This is what you have to prepare for, and if you pass this test, we'll allow you to give dividends," or whatever, whatever they want to do, acquire something new.

Peirce: So the problem is then you're sort of studying to the test. You're trying to please the regulators, but you're not thinking on your own, hey, what are the actual risks that we face? You're just allowing the regulators to identify the risks and then you're planning for those risks. I think that's potentially going to lead to blind spots.

Beckworth: Okay. Well, that first part of the book also looks at FDIC, deposit insurance, and it's just privatizing deposit insurance. So talk about that. How would that work and what would it solve?

FDIC and Deposit Insurance

Peirce: Well. This chapter by Thomas Hogan and Christine Johnson says, "Look, there are alternatives to FDIC insurance." And it goes back and it looks at some of the academic literature, which is fairly uniform in saying that government-provided deposit insurance is not helpful to financial stability. And so, it says, "Hey, what could we do instead?" And one idea is to privatize it completely. But the chapter also offers the idea that you could still require people to have it, but you could have it be privately provided, or you could allow people to choose whether they want to have it or not.

Peirce: So there are different approaches, but I mean, it would work the same way that it works now, except you'd have a private provider. If you wanted to fully privatize it, you'd have a private provider of insurance. You could administer it privately also, which is another option.

Beckworth: This is interesting because it's very different than a previous guest I had on, Morgan Ricks. I don't know if you've heard that podcast, but he wants to actually expand the FDIC, go the other direction. He wants to basically shadow banking covered by the FDIC. But here's, I guess, the question I have is, it seems that one of the issues of being in a democracy is that at the end of the day, the government's always going to be turned to as the backstop or the insurance in the midst of a truly systemic crisis.

Beckworth: Now maybe we can avoid them with these different approaches. We don't ever get there in the first place. But like the great depression, it was a systemic event and I would attribute a lot of it to bad Fed policy. But it seems like given that we're in democracy, we have politicians, people will always... So even if we go down this path of privatizing FDIC, if something bad happens beyond the control of the banks, they're going to call their politicians up. The politicians will demand some kind of change and will revert back to government bailouts of some kind.

Peirce: Yeah, I mean, that's a real concern. But I think one point is that, the academic research does show that the government-provided deposit insurance makes it more likely that we'll have that kind of event. So that's one question. Whether it's politically feasible to eliminate it is another. You could pair it back. It's at 250,000, which is substantially higher than the average person has in her bank account. So, one option is just to pair it back.

Peirce: But on the bigger question of, well, surely we're just going to have bailouts anyway, so we might as well prepare for that. I mean, that's kind of the point that Garrett Jones makes in his chapter. He says, "Look, it's all well and good to say before a crisis, that you don't like bailouts. But we all know that when you're there in the government, when there's a crisis, you're going to be in favor of bailouts." And so, he has some ideas about maybe how to plan for that.

Peirce: For example, his idea would be that you could have speed bankruptcy where the debt converts to equity in a crisis, and that would solve some of those problems. So I think it's fair to think about those questions, but we can try to increase the amount that the market is watching itself to make a crisis less likely. So certainly, I'm not advocating that if we get rid of deposit insurance, we eliminate "too big to fail". I don't think that's true. I think the question is, let's just think about it again and think about whether we can do this in a better way or whether we like it the way it is.

Beckworth: Yeah. I don't want to be defeatist either because you can go to the other extreme and just sit on your hands and do nothing. But I agree, it's important to think through these issues. So find ways to, at least on the margin, make the system better, safer. I would advocate from, from where I sit, which is a macroeconomist, the Fed needs to do a better job. I mean, there'll always a whole set of separate issues in terms of financial management, financial regulation. But the Fed itself, I think, often can exacerbate the problems, and poorly designed financial systems.

Peirce: Well, maybe if they weren't so busy doing regulation and supervision, they'd have more time to think about monetary policy.

Beckworth: Would you suggest they separate the two?

Peirce: I think it's definitely worth considering. The Fed has gotten a lot of power. Dodd-Frank gave the Fed a lot of new regulatory and supervisory power, and it's not clear to me that you can really have the attention that you need on that while also dealing with monetary policy, which is fairly complicated. It also leads to bad incentives. So if you make a mistake on the regulatory side, can you somehow cover that up with your powers as a monetary authority? Can you cover it up with your emergency liquidity facilities that you then use to bail out an insolvent institution? I think it's worth considering whether there might be a better way to do the regulation.

Beckworth: I think the Bank of Canada doesn't deal with regulatory issues. It's strictly monetary policy organizations. So it wouldn't be unprecedented to have the two responsibilities separate. And historically, there have been other agencies that deal with these issues, right? The Office of Comptroller of the Currency, state bank regulators, I mean-

Peirce: You've got the FDIC too, so-

Beckworth: Yeah, FDIC. So it wouldn't be a huge leap to say, "We're going to break these responsibilities apart. The Fed sticks purely to monetary policy." Something else that you bring up in the book, and this goes in line with what we've been talking about. And this is Title II of Dodd-Frank. This is the Orderly Liquidation Authority. This is the idea of creating living wills for banks should a crisis occur, should we have another Lehman. It'd be an orderly way to unfold and deal with a bankruptcy. So I believe your chapter question is the very premise of this, of like Lehman's events, some of the banks that happened during the crisis. But tell us about that idea.

Peirce: Yeah. Peter Wallison wrote that chapter. There's one thing which is the banks are required to prepare a living will and figure out what would happen if they failed. And then, there's the second idea of the Orderly Liquidation Authority for large financial institutions where if a large financial institution is teetering on failure, the government can come in and they can take it over. And in this case, the Dodd-Frank gave the authority to the FDIC figuring, well, it has this experience with banks, maybe it could do this with other financial institutions, which is questionable.

Peirce: But in any event, so the idea is that they would come in and then they would be able to, well, you would think liquidate based on the name Orderly Liquidation Authority. But as Peter Wallison points out, they've sort of moved beyond that to, their goal is to resuscitate and not liquidate. So that's a question. He raises questions in his chapter about the legal authority for the FDIC to do what it plans to do.

Peirce: But he also says a better approach. He's, again, one of these proponents of just going to higher capital and having these financial institutions be stronger, and not having to deal with the Orderly Liquidation Authority at all. There's another idea which we did not include in our book, but I think there's been a lot of good work done on this by Hoover, and that is looking at ways to make bankruptcy, so that it would work better for financial institutions. There's really been some excellent work on that, and I think that's a good road to go down in terms of trying to solve "too big to fail".

Beckworth: Let's talk about Lehman in particular here, the case of that. In that chapter, I mean, it mentions the reason Lehman collapsed because the Fed and the treasury suddenly changed their approach, or they were bailing out banks, created expectations, and then suddenly Lehman hits the brick wall and blows up. But let's say that it hadn't done that. Let's say it didn't save Bear Stearns, had been liquidating it, had forced these banks to close down. Could you have an orderly liquidation? I mean, could you have this process work, in your view, if you did it right?

Was an Orderly Liquidation of Lehman Possible?

Peirce: Yeah, I mean, first of all, I would say that primary responsibility for Lehman belongs with Lehman. So while I do blame the policy for changing, the Fed for changing policy mid-course, to be fair, Lehman is responsible for Lehman. So I would argue that you could have... I think the bankruptcy was fairly effective the way it happened. A lot of people would disagree with me on that, but I think that it went through bankruptcy, and bankruptcy worked. But I think bankruptcy could work better if there had been more planning, for one. And two, if we had had some of changes that people at Hoover and elsewhere are recommending to make bankruptcy work better.

Beckworth: I guess, the critique or the pushback against that view is, well, Lehman created a global systemic financial crisis, right? It was Lehman that really turned what was a worsening situation into a very wicked situation for the financial system. And that, over the weekend they couldn't do an orderly liquidation. It's so complicated, so big. So how do you respond to that?

Peirce: Well, I mean, things were bad at that time. So Lehman going bankrupt, I'm just not convinced that that in itself was the cause. I mean, you had AIG in the background too with its problems. You had a lot of financial stress at the time. So I just am not sure it's really a fair comparison to say, "If Lehman had been bailed out, the world would have been a better place." It might have just prolonged the pain that we had. So I think it's difficult to go back and try to rewrite history, but I'm not convinced that having Title II in place would have really solved our problems.

Beckworth: Okay. I mean, another perspective might be that Title II might have worked if, again, the Fed and the treasury department had been consistent in their policies, so you wouldn't have had the big shock, the big surprise.

Peirce: But if you really had that consistency, Lehman would have really felt the fire, and would have-

Beckworth: Sooner.

Peirce: Yeah. And they would have made efforts to figure out what they were going to do. I mean, again, there are a lot of stories about what happened at the time. But certainly people say that Lehman was kind of sitting back waiting for someone else to help it instead of being proactive. I'm not going to take a stand one way or the other except to say that when a company is experiencing these kind of problems, I do think it's primarily that company's responsibility to figure a way out. And bankruptcy has been the traditional way.

Beckworth: All right. Let's move to the third section of the book. And this is your area of specialty here. You look at securities and derivative market regulation. And before we get to your chapter, there's one chapter you've already mentioned by a former SEC Commissioner, Dan Gallagher. Let's talk about that. And in that, and you've already alluded to this, but he argues against self-regulation for these broker dealers. Is that right?

Peirce: Well, I think that's too strong of a statement. What he's arguing is that what we have now and what we call self-regulation is not actually self-regulation. We have FINRA, which is the allegedly self-regulatory organization in the broker-dealer space. They don't even call themselves a self regulator anymore, to be fair to them. They call themselves an independent regulatory organization. But what a lot of people feel is that they look a lot like a government regulator and there's not really that much difference between FINRA and the SEC.

Peirce: And so, what Commissioner Gallagher is arguing is self-regulation could work, but let's not kid ourselves that what we have is self-regulation. So we can think about ways to get back to self-regulation, but that's not necessarily what we have. And again, I'm not trying to overstate the case. I don't want to speak for him in terms of what he thinks of FINRA. I have some concerns about the way FINRA operates.

Peirce: I've written separately on this and have some concerns that they're kind of getting the best of both worlds from their perspective, and that we really do need to rethink whether that's an effective way to regulate broker dealers. Is it an effective way to protect people? It may be better to either go one way or the other, either move to self-regulation or move it back to the SEC.

Beckworth: Okay. Well, let's talk about your chapter. You write about derivatives and Dodd-Frank changed how they were regulated. Tell us what Dodd-Frank did to that market.

Dodd-Frank and Derivatives Regulation

Peirce: The over-the-counter derivatives market was one where firms engaged in bilateral transactions. And a lot of people after the crisis said, "Look, derivatives were really to blame." And they point to the case of AIG and say, "Look, derivatives brought down AIG. If we had regulated them differently than we did, then we wouldn't have had a problem." And so, OTC derivatives were exempt from regulation by the SEC and CFTC. The banks that engaged in derivatives were obviously heavily regulated.

Beckworth: Give us one good example of a derivative back then that caused a lot of problems.

Peirce: Well, the AIG derivatives were derivatives written related to the housing to mortgages… So those are the ones that get the most attention. And so, the solution to this was, let's force these things to be cleared centrally. Derivatives tend to be long-lived, so months or years long. And so, before, you just had a bilateral transaction, so you had two firms, and the firms just had that transaction open between them for months or years. Now what they're saying is once you do the transaction, you take it and you go to a central clearing house, which will then become the buyer to each seller and the seller to each buyer.

Peirce: And so, you have these contracts that are then housed in a clearing house. People were attracted to that idea because they said it will take risk out of the financial system, out of these large financial institutions, and put it in a central place, and we can watch that central place pretty closely. Now, one problem is that the type of derivatives that AIG was involved with weren't standardized enough. They were very carefully tailored to particular securities. So they wouldn't be clear no matter what.

Peirce: But putting that aside, one of the things that people overlooked when they created the solution was that clearing houses themselves then become these immensely important entities that have interactions with every major financial institution, and usually on multiple levels. So not only is the institution a member of the clearing house, but maybe they're a bank that is lending money to the clearing house or... And so, if you have a problem, it's going to reverberate throughout the whole financial system through the clearing house.

Peirce: And so, that's why I question, in my chapter, whether a clearing mandate forcing people to use clearing houses is such a good idea. I think it would be better to eliminate the mandate and let markets organically develop.

Beckworth: So what used to be a number of bilateral relationships between financial firms and in other buyers, sellers, have all been put into one place, which I think you're saying creates a massive systemic risk, a massive nother Lehman or AIG that's connected all around the world. And so, you just put a little damage in there and it goes everywhere. Has anyone responded to that critique? Did that concern of yours?

Peirce: Well, and I'm not the first one to raise this. Even while Dodd-Frank was being drafted, there were people who were saying, "Wait, this is a problem," including Craig Pirrong from University of Houston. He was raising the issue. That argument didn't get any traction during Dodd-Frank drafting. The only traction it got, the Fed understood this was a problem. Title VIII was put into Dodd-Frank to deal with clearing houses, because people knew there was an issue. But no one really focused on it.

Peirce: Proponents of Dodd-Frank didn't focus on it until recently, when people started having conversations about what would happen if one of the clearing houses, big clearing members, failed. What would happen if two of them failed? Who would be on the hook? And so, people are starting to think through those issues and they're starting to worry. But people's solution is not to eliminate the clearing mandate. It's to say, "Well, we're going to watch these things really closely." To me it sounds a little like a GSE.

Beckworth: Yeah. Exactly. This is one of the examples of how Dodd-Frank may actually be making us less safe.

Peirce: Yeah. I think so.

Beckworth: In the sense that they're consolidating all these risks together under one setting. So who would run one of these clearing houses? A big bank on Wall Street or some other big financial firm?

Peirce: Well, they're run in different ways. Typically, they're associated with an exchange. Clearing houses existed for a long time, and they existed in the future space, and in the securities world as well. But the problem is that I think of a clearing house, I think to be most effective, it would be run by the members themselves so they could police one another. When you have public ownership, for example, of a clearing house, then you have more competing interests in there. And so, it becomes much more complicated to figure out who's on the hook if there's a problem.

Peirce: Ben Bernanke actually wrote about clearing houses because there was a problem with clearing houses in the '87 crash, and the Fed came in, saved the day. His point is, look, you have to think of the Fed as being the backstop for the clearing houses. Let's just be honest. The Fed is the backstop. That's how Dodd-Frank is written, to have the Fed as the backstop.

Beckworth: Okay. So the only advantage is there's more information now. You have a better sense of knowing what's going on, but you still have... Or if anything, you've concentrated the risk-

Peirce: Correct. Correct.

Beckworth: Made it more susceptible. I mean, I guess I can understand the motivation even though it's created these other problems. Because I remember, for example, a 60-minutes episode back then that talked about, oh my goodness, we don't know how many CDS's need to be cleared. CDS is Credit Default Swap. It's insurance on a mortgage back security or some kind of bond. So the movie, The Big Short is a great tool to learn more about this. But people are literally betting against these mortgage back bonds collapsing. And so 60 minutes, to go back to that, they said, "It may be as high as $50 trillion. We just don't know." And you're like, "Oh my goodness."

Peirce: Right. The numbers get a little bit...

Beckworth: And that was the notional. Now I know once you... The net amount's much smaller, but it creates this fear that we don't even know. We don't even know how much is out there. And so, we've got to do something. We've got to move it to a clearing house. But we solve one problem, maybe the information problem, but then we create a whole new beast, the systemic problem.

Peirce: Yeah. I mean, there was a problem in that, to me, it's good the regulators now have a better window into it, although it's not clear that that's working maybe as well as it should. It's good that we have that improvement, but it's especially important for firms to know what their exposures to one another are. And I think there was definitely room for improvement. Before the crisis, these firms were not as aware as they should have been. But they were private sector and the New York Fed was involved in trying to get some efforts underway to improve that. The other thing to remember is that CDS also play a valuable role in providing information. And so, we should really be careful about doing things that will stop the use of CDS.

Beckworth: Now, you mentioned that many of the CDS's, leading up to the crisis, were very customized so they wouldn't have worked real well on an exchange or a clearing house. So, does that mean that this idea really didn't solve the CDS problem if it were to emerge again?

Peirce: No, because only standardized CDS and other derivatives can be cleared. It's not going to work effectively because you need to have enough trading to kind of establish what the pricing is. And so, it won't work for those kind of bespoke contracts.

Beckworth: Okay. Well, let's move to a chapter by Holly Bell on algorithmic trading. So talk about that. Why has that become such an issue lately, and what is her thoughts on it?

Should We Regulate Algorithmic Trading?

Peirce: I think what made it an issue is Michael Lewis's book, Flash Boys.

Beckworth: Yeah, high-frequency trading.

Peirce: High-frequency trading, and thinking about, are our equity markets rigged? And so, because you get all this attention on it, people start to worry a lot about the state of our markets. And Holly Bell says, "Let's just take a step back. Don't worry about the markets being rigged." There are a lot of changes that are underway to address some of these concerns. And so, competition in innovation are leading people to think, "Okay, if you want to be in a marketplace without high-frequency trading, we have a way to do that.

Peirce: For competitive reasons, we're going to do this and see if we can make a go of it. And so, she says, "Let's just hold off on trying to regulate until we see what the markets are doing to regulate themselves through competition.

Beckworth: Okay. So we shouldn't be too alarmed yet.

Peirce: She would say, "Don't be too alarmed yet."

Beckworth: Okay. Very well. Let's move on then to another part of a book. And this is a really controversial part of Dodd-Frank, and this is the consumer finance protection part. The Consumer Financial Protection Bureau was created by this law, and there's been a lot of controversy because it's funded by the Fed, which makes money off the seigniorage. Doesn't go to the Congress for funding. So this agency that's now within the Fed, it regulates consumer finance issues, but doesn't depend on Congress for funding. It also is a single leader versus a commission. So talk about that and some of the issues that have come up with that, and why we should care about it.

Peirce: We should care because the CFPB, as it's known, has the ability to really affect everyday people's lives in a very direct way. It affects the ability of people to get credit for emergency needs as well as for houses and cars. And so, it does matter that it works well. Some of the issues that have arisen, you highlighted them. People are very concerned about the lack of accountability, and we've seen that that lack of accountability has translated into some activities that are fairly questionable in terms of regulating outside of their jurisdiction, regulating very aggressively.

Peirce: A court several months ago concluded that the structure of the CFPB is unconstitutional, and so made a tweak to make it work constitutionally. We'll see what happens with that litigation as it moves forward. And we'll see what happens with the new administration. The way that the CFPB is set up, there is a fixed term for the director. And so, it'll be interesting to see what happens in the new administration.

Beckworth: So is the tweak turning it into more of a commission like the SEC?

Peirce: No, and that's what a lot of people are recommending, that it be a commission structure. But what it did is it made it easier for the president to fire the head, because the way the statute was written, it wasn't clear that the president could fire the head.

Beckworth: Give some examples of where it has misstepped its boundaries, maybe you've been a little too aggressive.

Peirce: Well, for example, it's gotten into the area of auto-lending, and it's been very aggressive in that area. It actually through enforcement actions has kind of rewritten the way auto finance is done, and a lot of people are questioning whether in doing that, it was kind of skirting the authority. Interestingly, auto dealers were specifically not covered by Dodd-Frank, and so some people felt like the CFPB had gone too far in its auto financing cases.

Peirce: There are many examples of where it's been quite heavy handed, in the way that it approaches things. And, again, that's something that would be less likely if you had more accountability. But there've been some instances where the tactics that the Bureau uses have raised questions with people.

Beckworth: Now, this agency is backed or has the support of Senator Elizabeth Warren, right? So it's a little bit of a minefield to go in there and try to push reform.

Peirce: Yeah. I mean, it has the support of lots of people, people who are Republicans and people who are Democrats. Many support the agency's objectives. But there is a difference of opinion in how the entity should be structured. And there is a very vociferous difference of opinion on that.

Beckworth: Right, on how to implement and-

Peirce: Yes.

Beckworth: ... fulfill its objective. Okay. What about the financial innovation? Because you have a section on financial innovation in the book. Is it being hampered by regulation, and what can we do if so?

Peirce: I think that people who write about this area, including our authors, would say it is being hampered by regulation. And their argument would be, let's just let the innovation play out to the extent that we can make sure the consumers are protected. But beyond that, let's let it play out, because innovation can actually end up furthering the goals of regulation, which is increasing access, increasing competition, making sure that people who have few options have more options for credit. And so, the attitude that our authors in our book take is, let's try to allow this to happen, as much unfettered as we can.

Peirce: Now, of course, we need to have the basic protections in place, basic fraud protections. But let's not put unnecessary barriers in place. It's difficult for regulators because often the regulatory structure is not flexible enough to allow for some of these innovations. So it's going to take some work on their part to figure out how they can accommodate innovation. One regulator that's been thinking a lot about that recently is the Office of the Comptroller of the Currency, which is kind of looking for ways to become more innovation-friendly. It's acknowledged that in the past it hasn't been. And so it's trying to figure out what it can do on that front.

Beckworth: Interesting. What are some of the areas, some of the innovations where we're finding this friction?

Peirce: Well, Bitcoin is one-

Beckworth: Bitcoin. Okay.

Peirce: ... obvious one and other cryptocurrencies. And then, you're seeing it in marketplace, so online lending platforms. Robo-advisors are another area. And then, on the securities side, robo-advisors is one, but there are also innovations related to funding companies. So Congress has addressed some of this with the jobs act, which allowed for crowdfunding. But there are still questions about whether additional innovation could be brought to life if there were even a freer ability for people to raise capital.

Beckworth: Okay. Well, a lot of great ideas in the book. What are the prospects going forward? We have a new president, a Congress that's controlled by Republicans. We have the CHOICE Act. Maybe speak to the CHOICE Act. What does the CHOICE Act do that's in line with the spirit of this book? And what is your sense, going forward, of what will happen with the Trump administration?

Peirce: Yeah, I mean, the CHOICE Act covers a lot of things, but one thing it does do is it allows regulated banks to choose that they will have higher capital in exchange for getting rid of some of the regulations that they would otherwise face. So that's certainly in line with what we're talking about in the book. In terms of prospects. I think there is a real interest in doing something on financial regulation and really taking a serious look at Dodd-Frank, and looking at ways we can improve financial regulations. So I'm optimistic that we will see some change.

Peirce: The goal of these changes has to always be increasing financial stability and also increasing competition, making sure that barriers to entry are low, making sure that there is the ability for people who want to come in and serve these markets to come in. Right now, if you want to be a financial services company, you might decide you don't want to serve low-income consumers because you're worried that the CFPB is going to punish you for being in that space. And that's crazy. That's not the result that we want.

Peirce: So I'm optimistic that with the interest in doing something, the president has expressed interest in doing something on financial regulation. Certainly, chairman Hensarling is moving forward with the next iteration of the CHOICE Act. And I think there's interest on the Senate side as well. So I'm expecting that we will see something.

Beckworth: Well, that's exciting. Our guest today has been Hester Peirce. She is the co-editor of the book, Reframing Financial Regulation: Enhancing Stability and Protecting Consumers. Thank you, Hester, for being on the show.

Peirce: Thanks, David.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.