Financial Regulation

Back to the good ol’ days of 2008.

Immediately after the GOP took the House last year, Alabama Republican and chairman of the House banking committee Spencer Bachus made the mistake of saying what he actually believes about financial regulation. “In Washington, the view is that the banks are to be regulated,” he told the Birmingham News, “and my view is that Washington and the regulators are there to serve the banks.” This view is consistent with thirty years of Republican-backed financial deregulation as well as with the conservative explanation of what went wrong in the financial crisis. And if the Republicans manage to take both elected branches of the government next year, this is likely to be the spirit in which they’ll approach the post-Dodd-Frank era.

On July 21, 2010, President Obama signed the Dodd- Frank Wall Street Reform and Consumer Protection Act into law. A large reworking of the financial economy, it was opposed by Republicans from the beginning. House Republicans voted in committee against crucial planks like derivatives reform and throughout the entire process added loopholes and exemptions, including one that removed auto lending from the consumer financial protection umbrella. With few exemptions, notably on the matter of auditing the Federal Reserve, there was no bipartisan support for new regulations.

Going forward, the Republicans’ intentions with respect to Dodd-Frank are already clear: in Congress, they have introduced repeal legislation, and every major Republican presidential candidate has pledged to repeal Dodd- Frank in its entirety. It’s fair to take them at their word. Even if a Republican majority set out to kill the bill in one fell swoop but was blocked by a Democratic filibuster, it wouldn’t really matter. That’s because there are a series of simple steps Republicans can take to pull apart Dodd- Frank piece by piece. The collective effect would be similar to that of an overall repeal and would leave the global financial system in serious peril.

Why does the GOP view Dodd-Frank as an unnecessary overreach? In their minds, there’s no problem to solve where the financial system is concerned. While the vast majority of economists and financial experts view the 2008 collapse of the banking sector, and the ensuing Great Recession, as the result of decades of unrestrained, unregulated experimentation by Wall Street firms, the right rejects this view. Conservatives see the crash as a cautionary tale about government intervention in the housing markets, in which the subprime mortgage boom was egged on by community organizers and government-sponsored enterprises like Fannie Mae. That George W. Bush was one of the biggest backers of “the ownership society” and that the much-maligned community activists were actually shouting early warnings about problems in the housing market are inconvenient facts to be ignored. As if suffering from a form of ideological color blindness, wherever there are large market failures in the current infrastructure of our financial system, conservatives can’t see the problems themselves, only the presence of the government.

It has long been the case that, in the conservative imagination, the best market is one with the least amount of rules. In the 1990s, Senator Phil Gramm infamously told SEC Chair Arthur Levitt that “unless the waters are crimson with the blood of investors, I don’t want you embarking on any regulatory flights of fancy.” This guiding principle led many at Alan Greenspan’s Federal Reserve to ignore signs of fraud in subprime lending early on, despite the warnings. At the same time, there was a very conscious effort to tie state regulators in knots whenever possible, mostly by overruling, or “preempting,” state laws on behalf of large national banks. And in the years since the crisis, even without controlling the White House and the Senate, Republicans have managed to block key presidential appointments, tighten budgets, and harass regulators at every turn. All of these strategies— softening federal oversight, hampering regulatory institutions, and interfering in any state-level attempts to provide tough oversight of the financial industry—would surely be reprised by a Republican White House and Congress in each of the major battlegrounds on financial reform.

Take the issue of consumer protection. The root cause of the financial crisis was an abusive, predatory, unregulated lending market that drove lots of bad mortgages to unknowing consumers as well as investors. Though most regulatory agencies list consumer protection among their goals, no regulator was dedicated explicitly to the task until Dodd- Frank mandated the creation of the new Consumer Financial Protection Bureau. Reformers were careful to structure the CFPB for maximum clout and independence. It has a single director, and its budget, a guaranteed appropriation from the Federal Reserve, cannot be cut by Congress.

These features are exactly what the GOP wants to dismantle. Senate Republicans have signed a letter declaring that they’ll oppose any candidate for director of the CFPB unless the bureau is subjected to the congressional appropriation process, allowing the next aspiring Phil Gramm to slash its budget at first chance. They also want to replace the director with a board and muddle the mission of the bureau away from its consumer focus. All these moves will lead to gridlock, creating a much weaker CFPB.

Republicans would also like to undo the components of Dodd-Frank that force hitherto unregulated, “over the counter” derivative trading into open exchanges that are transparent and well regulated. During the decade leading up to the financial crash, derivatives, once mainly used by companies to hedge risk on commodities with fluctuating prices (e.g., oil for airlines), were seized upon by Wall Street, and the size of this potentially explosive market skyrocketed. By 2003, Warren Buffet was calling derivatives “financial weapons of mass destruction.” When the markets crashed in 2008, derivatives transactions had gotten so large yet so murky that it was nearly impossible to know who was on the hook for the tremendous losses. In an attempt to prevent a repeat of these circumstances, Dodd-Frank requires derivatives trading to take place in public exchanges, and obliges firms to put up enough collateral to ensure that, if their bets go bad, they can pay back investors (unlike AIG, which required billions of taxpayer funds to do so).

During negotiations over the law, there was a big fight over what kinds of derivatives would be exempted from these rules. There was also a battle over which kinds of nonfinancial firms, “end users” like airlines and industry, would be exempt. Republicans will try to expand these end user exemptions and narrow the types of derivatives that have to follow the new rules laid out in Dodd-Frank, bringing us closer to the pre-crisis status quo. There’s already movement in the House to try to rewrite the parts of Dodd-Frank dealing with price transparency in derivatives trading so that less information has to be disclosed.

A third aspect of Dodd-Frank that the GOP has in its crosshairs is the law’s effort to deal with the “too big to fail” problem. In the wake of the financial crisis, many economists argued that the best and perhaps only way to avoid the need for massive bailouts in the future would be to cut the nation’s biggest financial institutions down to size, such that the failure of any one would not drag down the entire financial system. That’s not the course the Obama administration and congressional Democrats took. Instead, with Dodd-Frank, they placed a special set of regulations on the largest and most complicated financial firms, known as “systemically important financial institutions” firms—companies like Goldman Sachs and Citigroup. Under the law, these behemoths are required to hold more capital in reserve than they did before the crisis, and must prepare “living wills” so the government can take control of them if they do fail, cushioning the impact on the rest of the economy. When Barney Frank bragged that there “will be death panels enacted by this Congress, but they will be for nonbank financial institutions,” he was referring to this living-will provision and the government’s new authority to take over these institutions in the event of their failure. Several of the firms would also likely fall under the Volcker Rule, which bans firms with FDIC protection from outright gambling with a taxpayer backstop and secretly betting against the interests of their own clients. Needless to say, the banks would be glad not to have to deal with any of these new rules.

Beyond these three main areas of regulation, virtually all the other reforms in Dodd-Frank would be at risk from Republican efforts to stop regulators from writing the necessary rules and implementing them in the marketplace. Funding for the agencies will be important here; House Republicans have already attempted to radically cut the budget of the U.S. Commodity Futures Trading Commission. Nor will GOP attacks on financial regulation be limited to Dodd- Frank. Most of the major presidential candidates have stated that they intend to repeal Sarbanes-Oxley, the financial reporting mandate put into place after the corporate scandals at Enron and WorldCom.

If laws like Sarbanes-Oxley and Dodd-Frank are repealed or eviscerated in the ways Republicans have explicitly called for—or have at least hinted at—it is not hard to imagine the possible consequences. The largest firms would be dangerously risky, continuing to exert way too much influence over the markets and to keep finding new, innovative ways to gamble with other people’s money. Reforms that would limit abusive practices across the market won’t be put into place. The financial markets will be set up to generate maximum panic and confusion in a crisis. When the next set of problems starts to occur in the financial market, we’ll be in no better shape to deal with the crisis than we were before. Financial firms are constantly creating new, complex products and services that could pose risks to the entire financial system but are little understood by regulators. Unless agencies are given the funding and mandate to keep up with Wall Street’s innovations, it will be difficult if not impossible to stop the next crisis at an early stage.

It may be hard to fathom why Republicans would want to do away with commonsense regulations meant to stop the kinds of financial practices that wrecked the American economy—especially when, in the eyes of many, those regulations didn’t go far enough. But if the story you tell, against all available evidence, is that the government is the primary culprit, and the financial markets work fine without any serious oversight, then the only logical conclusion is to govern like you are there to serve the banks.

[Return to What if Obama Loses: Imagining the consequences of a GOP victory]

Michael Konczal

Michael Konczal is a fellow with the Roosevelt Institute.