Will Dodd-Frank Ever Work?

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By Professor Thomas Clarke, University of Technology, Sydney

Amounting to 2,600 pages of legislation Dodd-Frank was certainly a comprehensive and determined effort to rein in the US finance sector, the question is will it succeed in doing so? Gordon and Muller (2010) argue that while the Federal Deposit Insurance Corporation may provide the means for an orderly liquidation of individual failed banks, it does not offer the possibility of dealing effectively with systemic failure of inter-connected financial institutions. They suggest instead a Systemic Emergency Insurance Fund of $1 trillion, funded by risk-adjusted assessments of all major financial firms. This would mutualise systemic risk and provide a major incentive for firms to warn regulators of impending risk. Coffee (2012:i) argues that it is only after a catastrophic market collapse that legislators and regulators are able to overcome the resistance of the financial community and adopt comprehensive reform legislation such as Dodd-Frank, but invariably this is followed by “increasingly equivocal implementation of the new legislation, tepid enforcement, and eventual legislative erosion.”

Despite the vast effort of the US legislators who put together the Dodd-Frank Act there are definite indications of lack of traction. Firstly Dodd-Frank depended more than Sarbanes-Oxley on administrative implementation by a host of regulatory agencies because Congress was not in a position to determine detailed issues such as appropriate regimes for capital adequacy, liquidity ratios, OTC derivatives, and similar complex financial issues. Regulators are confronted by finance executives determined to retain and protect their executive compensation, high leverage, bank profitability, and managerial discretion (Coffee 2012:11). An early indication of the formidable indifference of US finance executives in 2008/2009 to regulation and public scrutiny was the total refusal of to give up hugely inflated executive bonuses at companies such as AIG which had failed during the financial crisis, and was only rescued with a US government, taxpayer funded, rescue package of support amounting to $180 billion. (In fact at almost all the financial companies who received assistance under the original $700 billion Troubled Asset Relief Program (TARP), the executives resented so much the constraints that TARP imposed on their compensation packages, that they scrambled to repay the money to the US government before the salary restrictions could seriously impact on them).

Another sharp indicator that little has changed in the US investment banks are recent developments at Goldman Sachs. It must be recognised that Goldman Sachs sailed through the financial crisis adopting the mantle of a white knight (though in fact it had engaged in almost all of the same doubtful practices as the other Wall Street banks and initiated many of them). Goldman Sachs not only provided the US Treasurer at the time of the crisis Hank Poulsen, who was primarily responsible for the rescue effort, but earned tens of billions assisting the government in the rescue effort. Then in April 2010 the SEC announced it was suing Goldman Sachs alleging that they had materially misstated facts regarding a synthetic CDO product it had originated in 2007. The SEC alleged that not only had Goldman Sachs allowed the Hedge Fund Paulson & Co to select the underlying mortgage obligations for the CDO, but omitted to mention to clients that Paulson’s $200 million invested was in shorting the stock, not a long term investment: that is rather than Paulson’s interests being in alignment with other investors, they were sharply conflicting. The SEC complaint stated that Paulson’s made $1 billion profit, while other investors lost a similar amount including ABN Amro and IKB Deutsche. In a settlement with the SEC in July 2010, Goldman Sachs agreed to pay $300 million to the US government and $250 million to investors. Lloyd Blankfein the Goldman Sachs CEO and Chairman insisted at a Congressional hearing that in the context of market making, betting against clients was a standard business practice.

The US Senate Permanent Subcommittee on Investigations concluded Goldman Sachs had “used net short positions to benefit from the downturn in the mortgage market, and designed, marketed, and sold CDOs in ways that created conflicts of interest with the firm’s clients and at times led to the bank’s profiting from the same products that caused substantial losses for its clients” (PSI 2011:8). On 14 March 2012 Greg Smith an executive director of Goldman Sachs took the unusual step of publishing his letter of resignation in the New York Times in which he stated: “...The environment now is as toxic and destructive as I have ever seen it. To put the problem in its simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money...I attend derivative sales meetings where not one single minute is spent asking questions about how we can help clients. Its purely about how we can make the most possible money off of them..” Yet the first Goldman Sachs Business Principle baldly states “Our clients' interests always come first.  Our experience shows that if we serve our clients well, our own success will follow” (Goldman Sachs 2011).

The impact of the global financial crisis continues to reverberate in the sovereign debt crisis. Considerable determination and resolve was demonstrated by the G20 in internationally and collaboratively tackling the crisis in 2008 and 2009. The effort to build a more robust international architecture of regulatory governance is impressive. However the concern is that the national and institutional commitment to implement regulation will diminish over time. More radical proposals to restructure and reorient financial institutions are still being considered such as in the UK the Vickers (2012) report on the structure of banking which contemplates separating investment from general banking; and the Kay (2012) report on how to resolve short termism.  In Europe the proposals for a tax on financial transactions threatens to constrain high velocity trading. However there are grounds to be sceptical about the willingness to face up to the fundamental causes of the financial crisis, and to engage in the institutional and debt restructuring that will be required to achieve a stable international recovery. Essential questions remain to be answered regarding the changes in the structure, regulation and governance of financial institutions that might be required to fundamentally transform risk-taking incentives and prudent decision-making, with the aim of achieving lasting change in the culture and behaviour within financial firms.

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