How Dodd-Frank Changed U.S. Finance

Monday, November 9, 2015
Jim Bourg/Reuters

Senior Fellow and Director of International Economics, Council on Foreign Relations

Annette L. Nazareth

Partner, Davis Polk & Wardwell LLP; Former Commissioner, U.S. Securities and Exchange Commission (2005-2008)

Patrick M. Parkinson

Managing Director, Promontory Financial Group; Former Director, Division of Banking Supervision and Regulation, Federal Reserve Board

Annette L. Nazareth, partner at Davis Polk & Wardwell; Patrick M. Parkinson, managing director at Promontory Financial Group; and CFR's Benn Steil join the Economist's Patrick Foulis to discuss the state of the U.S. financial sector and the impact of the Dodd-Frank Act. The panel considers the extent to which the legislation succeeded in achieving the goals of its sponsors and the challenges ahead for financial regulation in the United States.

This symposium is presented by the Maurice R. Greenberg Center for Geoeconomic Studies and is made possible through the generous support of Stephen C. Freidheim.

FOULIS: Well, thank you very much for joining us. I’m Patrick Foulis from The Economist. We’re here to discuss the aftermath of Dodd-Frank’s—I believe it’s 14,000 pages long, so I can guarantee you that measured in terms of pages per minute of panel discussion, we’re going to be remarkably efficient. (Laughter.)

We have a very illustrious panel to join us. And I think probably it’s best if you could each introduce yourself. Annette, perhaps you could start.

NAZARETH: OK. I’m Annette Nazareth. I’m a partner at Davis Polk & Wardwell. I work in the financial institutions group there. And I’m a former SEC commissioner.


PARKINSON: I’m Pat Parkinson. I’m a managing director at Promontory Financial Group. Formerly was director of banking supervision at the Fed.

STEIL: And I’m Benn Steil. I’m director of international economics here at the Council. I’ve given Senate testimony on central securities, depositories, CFTC testimony on exchange competition across borders, so very interested in these subjects.

FOULIS: OK. Thank you all.

Let’s start with the question of how far we’ve got. We’re almost at the end of this process of re-legislating after the financial crisis. Both Goldman and Morgan Stanley say they think we’re about 80 percent done. Annette, perhaps you could—

NAZARETH: I think that’s right. We’re very far along. I know a lot of folks follow the Davis Polk progress reports where we actually track all of the legislation that’s been written and how many rules are yet to come, but the fact of the matter is, it’s not that simple a metric because the most significant rule-makings have in fact been done, and a lot has already been implemented, so—for instance, that you wouldn’t count the Volcker Rule the same as you would some, you know, some small change to a SEC regulation. So in that sense, I would say at least 80 percent is finished.


PARKINSON: I think it’s well along too. Focusing on the bank regulatory framework, I think the key regs with respect to capital liquidity, what have you, are out there. I think the only caveat would be that some of these regulations set in train a process, and those processes have not reached their end. The one that I think could be quite impactful that’s not quite clear where it’s going to come out is the whole living wills process, where even though people say we need authority to break up the banks, well, the answer is you already have authority to break up the banks, but it has some due process associated with this living wills process. Pretty clear that regulators are not yet satisfied with the living wills of the eight large U.S. globally systemically important banks, but not yet clear whether they can be satisfied without making some difficult changes to their structure, so—

FOULIS: So for example, where we read—I think the headline in the last few days has been, banks will be required to issue a whole of debt that will be write-downable in the event of a crisis. Is that—is that a new thing, or is that a detail of the legislation which is being ironed out?

PARKINSON: Right. Well, it wasn’t actually in the legislation. It was part of this—called single point of entry resolution strategy that’s being implemented pursuant to the legislative direction to come up with an alternative to disorderly failure and bailouts. That one, not finalized; that was just a proposal that the Fed released about 10 days ago. And at the international level, the FSB just released the international version today. But I think a lot of that handwriting is already on the wall. There’ll be lots of comments from the industry and from others. But if experience is any guide, the final rule will look like the original proposal.

FOULIS: And Ben, one of the things about the legislations is it leaves a lot open to discretion and interpretation, and lots of rulebooks have to be written. Is that bit of the process near completion as well?

STEIL: Well, in terms of pure rule-writing, we’re almost literally halfway there. There are 390 rules in Dodd-Frank. Of course, those are divided up into myriad sub-rules as well. And we’re up to 193—271 that were supposed to have been finalized by September 30th, and we’ve got 193 now. So 50 percent of the way there; 70 percent in terms of where we’re supposed to be. But that doesn't tell us very much about the substance. I mean, the two areas where we’re materially behind schedule are derivatives and mortgages, and I would argue, in fact, that we’ve made some significant progress on the derivative side, whereas in the area of mortgages, I would argue that we’ve made almost no progress.

FOULIS: So on mortgages, what do we need to do there?

STEIL: Well, the obvious ones are reform of Fannie Mae and Freddie Mac, which are still unfortunately too politically toxic to touch.

FOULIS: Good luck.

NAZARETH: And not in the bill.

FOULIS: Right. (Laughter.) So it sounds like we’re sort of getting towards the end of this pretty opaque process. What’s—what good things have come out of this? What have we accomplished? Is the—is the system much safer, do you think?

NAZARETH: I think the system is safer. I think, you know, as Pat said, there has been a huge emphasis on capital and liquidity and leverage in the banking system. I think that the regulation of the derivatives markets is really quite significant. Although by rule count, we’re not quite halfway there, the fact of the matter is the CFTC is virtually finished, except for their capital and margin rules, with the implementation of Title VII, which was the derivatives part of the bill. And so we’ve taken a, you know, multitrillion-dollar derivatives market, and it’s now pervasively regulated, much more transparent, with transactions occurring on exchanges, with, you know, trade reporting, clearing of transactions through registered clearinghouses.

And, you know, the CFTC regulates the swaps, which represent about 90 percent of the market. Unfortunately, one of the problems with Dodd-Frank was it divided the market between swaps and security-based swaps, with security-based swaps representing maybe about 8 percent of the market. So that’s a very inefficient way to regulate. But if you look at the impact of what’s been implemented, it’s really quite significant.

FOULIS: So you pick out derivatives in particular as the—

NAZARETH: I think that’s quite significant, yes, derivatives.

FOULIS: And Pat, on bank capital, I mean, the raw numbers are the absolute amount of equity in the system has gone up by about 30 percent, I think. Is that—is that good enough? Is that what you might have hoped for?

PARKINSON: Well, I think there’s been substantial improvement. I think the number I’ve seen—in fact, this from Chairman Yellen’s testimony last week—is that for the eight global systemically important U.S. banks, they basically doubled their common equity capital since 2008, and their high-quality liquid assets are up by two-thirds since—I think it’s 2012.

You know, beyond that, I think the processes that regulators use to assess capital adequacy are stronger than they used to be, particularly the Fed in this CCAR process. It’s now a much more forward-looking process. I think a big problem with the way the regulatory system worked during the crisis was that a lot of the rules were sort of looking at the rearview mirror. So, you know, capital ratios just didn’t decline. Accounting standards don’t—then at that time require any sort of prompt recognition of deterioration and credit quality. But now, at least in principle and I think to an important extent in practice, the Fed’s stress-testing regime requires this forward-looking view so that, you know, you’re prepared for a bad economic scenario, which the industry obviously wasn’t in 2008.

FOULIS: Does the system have enough capital to withstand a similar event?

PARKINSON: Yea, I mean, that’s the design of the stress test. It’s a very severe economic scenario, as bad or worse in terms of the macroeconomic environment as 2008 and a financial market shock in terms of price volatility and illiquidity equally bad. So in that sense, yes.

If I found anything to worry about, one of the big problems in the last cycle was this so-called pro-cyclical behavior of the banks, that when the shock occurred, to preserve their own financial house, they pulled back from lending, they liquidated assets that led to a big increase in credit costs, which was very damaging to the economy. Regulators have tried to come up with a system where you have these buffers of capital among the—above the minimum requirements that in principle could be used, it would be an alternative to liquidating assets to make sure you’re still in good standing. Whether that works in practice I think depends on how banks view that and other creditors and the public views that. And I think that’s a pretty big unknown, both in the capital and the liquidity front. Will these—not like it’s any worse, but will these efforts to reduce pro-cyclicality be worth all the words that were expended on them?

FOULIS: And while we have you on the spot, Pat, so in a future crisis, would the Fed still have to extend liquidity on the same scale?

PARKINSON: Well, one would hope not. That was a pretty huge scale. You know, and I think part of the—particularly the liquidity regs and particularly their applications to foreign banking organizations who made a(n) especially heavy use of the Fed’s liquidity is designed to make sure that even if there is a severe shock, they can address that by reducing their holdings of high-quality liquid assets, basically Treasuries or other government securities, rather than come into the Fed.

On the other hand, I want to be careful. I think there is this tendency to conflate liquidity provision with solvency support, which exists in part because some of the things the Fed did with liquidity facilities was provide solvency support. They can’t do that anymore. But that’s a dangerous tendency because I think if the banks don’t feel comfortable using Fed liquidity in response to a shock, again, that could be very pro-cyclical and undesirable.

FOULIS: OK. And just on what’s improved, the conduct of banks, so their behavior, and what do you—that’s the sort of slightly unanswered question here because obviously, we’ve erected all of these rules, but what’s actually going on inside the (banks ?)?

STEIL: Well, let’s take the area of capital standards, where I do agree that we’ve made progress. The banks, according to the way they always behave quite naturally, are arbitraging that. For example, we’ve seen the proportion of securities on the balance sheet that are classified as hold to maturity go up very significantly because the capital requirements are considerably less than if they were part of a trading portfolio. So the banks are doing what they always do.

With regard to stress test, of course, they’re only as good as their assumptions. Our stress tests have been better than the European stress tests, but I don’t take too much comfort from that. I mean, the Europeans have some very distinct political problems in their stress tests that, thank goodness, we haven’t had yet—for example, whether to consider government debt riskless. We can have a debate about whether we should or should not here, but, you know, it’s more riskless. The last ECB stress test, for example, specified an adverse scenario in which deflation wasn’t possible. And they released the results of the stress test just as the whole Eurozone when into deflation. So already, it wasn’t credible off the bat. So we’ve got to make sure that ours are.

I would echo what Annette said about derivatives and moving more business on to central securities depositories. Been a big supporter of that, and I’ve actually been pleasantly surprised with the progress we’ve made.

With regard to swaps, naturally, there has been some regulatory arbitrage. There is more business being booked in London. But on the positive side of the equation—I think this is a very, very positive side—we’ve seen futurization of the swaps business. In other words, some swaps business that used to be done OTC is now taking place in the forms of standardized futures, and that’s happening primarily in the United States on the Chicago Mercantile Exchange rather than through LIFFE in London. So this is an activity that we’re more capable of regulating over here. And I think that’s been a very positive development. And the fact that we’re further along in the rule-making on the clearing of swaps and OTC derivatives than the Europeans are has actually been a competitive advantage for the United States. It explains why some European swaps are futures business has, in fact, moved to the United States.

FOULIS: Just to return to this question of culture, since, you know, any organization is only as good as its people—what is your sense? I mean, the banks have made a huge effort to talk about how their culture has changed, how their incentive structures have been altered. Beneath the bonnet, is anything different?

STEIL: Well, what—I mean, I know you’re going to get into this area eventually, it’s inevitable. But let’s take the Volcker Rule, for example, which I believe has been a great waste of effort and funds. It conflates risk-taking with proprietary trading, and the two can often be very, very different. But we’re moving in my view, in terms of how the banks are behaving, precisely in the wrong direction. Goldman, for example, there have been many, many articles in the press about how they’re moving their—the speculative part of their activities into securities that are considered from the perspective of Dodd-Frank rule-making to be non-tradable. So these are less liquid assets. So this is not less speculative activity; it’s just speculative activity being moved into areas that are not covered by the Volcker Rule.

Now, if you’re concerned about banks engaging in excessively risky activity, surely one way not to deal with it is to encourage them to engage in such activities in securities that are even less liquid than the ones you believed caused a problem in the first place.

FOULIS: Anyone else—either of you two on culture before we move on? Are there still 20-years-old with fingers on buttons that can lose billions of dollars hiding away?

NAZARETH: Well, unfortunately, I think there will always be some chance of that. And memories are generally quite short on Wall Street, as you know. But I think the people running those organizations haven’t forgotten the lessons from 2008, and I think there has been, as you said, a lot of emphasis recently on corporate culture. I know the Fed recently had a—I think last week had a program on that. I think there is a real effort, not just domestically but internationally as well—I mean, the FSB has been focused on it as well—to try to change or improve bank culture. But it takes a long time to do that.

FOULIS: OK. So it sounds like derivatives and capital are in a—both areas where lots of progress has been made, culture maybe. Let’s turn to some of the more obviously bad things to result from all the rule changes. And actually, I wonder if you could touch on the problem of regulatory overlap and underlap. We still have all of these different agencies. They seem in some cases to do the same things, some cases to have very different views, in one case to have very different views within the organization itself—

NAZARETH: (Chuckles.) I wonder what—who you’re talking about.

FOULIS: —in the case of the SEC. But we don’t seem to have resolved this question of the sort of regulatory soup.

NAZARETH: That’s right. I think that was probably the biggest disappointment to come out of Dodd-Frank. You know, there was a real opportunity there like there hadn’t been in decades to restructure the financial regulatory system, and we were unable to do it for, you know, political reasons, I’m sure. And so what we ended up with was the same number, essentially the same number of regulators with overlapping jurisdictions but yet different sort of mandates and missions, which makes it very difficult. The coordination effort is supposed to occur, you know, through the FSOC, the Financial Stability Oversight Council. I think that is still a work in progress. I think they’re trying very hard to coordinate. But it’s obviously been difficult.

I think the best example that we’ve seen recently in that regard is with the Volcker Rule, where the Volcker Rule was written, and the legislation required that five financial regulators oversee its implementation. And there has been a great deal of difficulty. First, I’m sure there was difficulty in coming to agreement in what the rules would say, but now, in the implementation process, it’s been—there has been virtually no guidance from the regulators on sort of day-to-day questions that come up on interpretations, and we’re told that that’s largely because they can’t agree on what to say.

FOULIS: If you’d been rewriting the rules, what would you have done with all the different agencies? Would you have abolished some of them?

NAZARETH: The agencies?


NAZARETH: I would have—I would have merged a number of the agencies. I think some of the work that had been done previously in two different administrations by the Treasury Department were at least an interesting start to merge the financial regulators, perhaps have, you know, certainly monetary policy with the Fed and put the, you know, regulatory—financial regulation in different buckets somehow. But to have all of these bank regulators and to have, you know, securities and futures in separate regulators is just crazy. I mean, we have the most complicated financial regulatory structure in the world.

FOULIS: But your ideal would be a monetary authority and mega-regulatory.

NAZARETH: Yeah. I would think we could have done it—the—maybe I was subject to U.K. envy—I think the way the English did it for a while seemed to work.

FOULIS: Well, actually, Britain—the odd thing is Britain reversed, of course.

NAZARETH: And they brought back—I know, I know. But they—not to the extent that—(chuckles)—they don’t look like us.

FOULIS: Pat, how do you think the Fed is doing on bank supervision in particular? The complaint for many of the banks is it doesn’t have the right people, it’s too academic, it doesn’t have its finger on the pulse and so on.

PARKINSON: I’m sure there are plenty of reasons to criticize what the Fed has done, but I don’t think those are really the core of it. I think interestingly, particularly the New York Fed, they brought a huge number of people in from the industry after the crisis. And some of the cultural problems and embarrassments that the New York Fed suffered I think was because it created some cultural challenges. They’ve maybe should have focused a little bit more on boarding properly some of these people who came from a very different, more bruising culture. But I don’t think that’s the core of the problem.

And I do think, in terms of the positive things the Fed has done—it’s interesting, the Fed for many, many years has argued that one of the reasons the Fed should have a role in bank supervision is that it has all this expertise—macro experts, payment system experts, financial markets experts—within its staff. And that’s true, but the irony is for—until quite recently, it really didn’t do a very effective—good job of tapping that expertise. The Fed was a very siloed place. It’s a much less siloed place today. Yellen and Tarullo and others talk about this new large institution supervision coordinating committee where it provides direction to the large bank supervision program and brings in the macroeconomists, the market experts, payment experts, et cetera. So I think that’s one regard in which it’s better.

Too academic? I don’t know. I would never consider myself much of an academic, sometimes cringed when the more academic people got their hands on things. But I wouldn't say it’s been a—it’s been a big problem.

FOULIS: Benn, one question for me—what’s the cost of all of this? I mean, I think JPMorgan has said it’s now spending $3 billion a year on compliance, and HSBC in Europe has come up with a pretty similar number.

STEIL: It’s significant. I mean, if this money were being spent on a re-regulation that’s genuinely productive in terms of preventing another systemic crisis, you could argue that it’s worth it, but some of it is clearly, clearly aimed at restructuring for the purposes of regulatory arbitrage. Quite naturally, when you seek to re-regulate what—something you call the banking industry, you’re going to have activities that are migrating outside the banking industry. And indeed, that’s what we’ve seen. Although the percentage of total banking assets controlled by the big four banks is almost identical to where it was at the beginning of the crisis, we’re seeing more activity over the course of implementation of Dodd-Frank moving to the shadow banking sector, and that includes areas that were problematic immediately after the crisis, off-balance-sheet facilities in particular.

One area I’m genuinely concerned about is just “too big to fail.” If you look at what the credit rating agencies are saying about it, Moody’s and Fitch recently concluded that there was no more government guarantee that the risk was essentially zero. S&P was a little more circumspect. They said it was 30 percent. But there was an academic study done a few years ago looking at credit spreads on the market. And they found that credit spreads are more sensitive to risk for all but the largest financial institutions. In other words, the ones that we’re calling SIFIs right now, according to the market, there is absolutely no reaction to increases in measures of risk, which would seem to indicate that despite all this re-regulation, that the market still believes that there are “too big to fail” institutions. And that, to the extent that that’s true, that’s a real failure of the re-regulation process.

FOULIS: Pat, do you agree with that?

PARKINSON: I think it’s a little more complicated than that. I would point out the GAO within the last year did a very big study looking both at a wide variety of academic studies of this issue and doing some more of their own. On the face of it, the “too big to fail” effect is far smaller than it used to be. I think where there is still a difference of opinion is whether the big reductions and the measured benefit are in part due to the fact that the system as a whole is considered less risky at the moment, and some fear that if it becomes to be perceived as more risky, those differentials will emerge again. But I think most people would say the problem has been diminished, if not eliminated.

One of the problems is even if, for example, this whole regulatory effort to make the big banks resolvable is a success, it will only be reflected completely in the spreads if investors believe it. And investors I think have been slow and cautious in taking on board the view that these programs have been successful in limiting it.

FOULIS: Last question before we turn to the audience and members here. Do you think the impact on the banking industry has been fully absorbed? If you look at the start of this year, there was a discussion about JPMorgan and whether it should break itself up; AIG, the big insurance company, Carl Icahn is pushing for it to be broken up. And the idea is if you get smaller, you avoid some of the most onerous rules. And in Europe, if you look right now at Credit Suisse, Deutsche Bank, Barclay’s, UBS, all are in the midst of similar discussions. So if the legislation and rules are largely written, has the impact on the industry been fully absorbed? Annette, perhaps you could start.

NAZARETH: I don’t—I don’t think it’s been fully absorbed yet. You know, among other things, we’re seeing a lot of the progress on regulation now moving to Europe. You know, the EU is somewhat behind us, as Ben said. And so while now there may be some arbitrages, I think a lot of those will be closed as those markets become regulated in much the same way. And I do think there has been a real commitment through the FSB and the G-20 and others to ensure that there isn’t a lot of arbitrage. So I—my sense is that while certainly the largest financial institutions are really trying to analyze, you know, what is the best location for them or what are the best businesses for them to be into, what are the costs of doing business, I don’t think that they have the full set of information that they need to make those decisions yet.

FOULIS: Pat, what’s your sense? I mean, could—do you think the JPMorgan-style bank with a $2 trillion balance sheet is a thing of the past? Is that going to still be around in probably 10 years?

PARKINSON: I think it’s—I think it’s still unclear. I do think partly this gets to the question of economically, are there economies of scale and scope in the banking industry? And I think most empirical studies have been all over the map of late, but they don’t find a whole lot of economies of scale, much less of scope. There have to be economies of scale in some areas—say, payments or securities custody or whatever with their huge fixed investments—to be a global player; it’s hard to imagine there aren’t scale economies associated with that, but they have a hard time finding them.

I think from the banking industry’s point of view, to the extent that they do really through these new regs tax scale and scope, at some point I think you’ll see them reconsidering, do I need to be not only a leader in global custody in payments but also in investment banking and also in mortgage banking and also in consumer landing, or if those economies of scope are, as I suspect, not quite as significant as they perceive, do you begin to decide that, well, I’m going to continue to want to be the leader in this area, but in light of these pressures on my cost or capital pressures from both regulators and shareholders, may have to think about just which business lines they want to have that scale—in which case they’ll want to get out.

FOULIS: Is that the—is that the unspoken objective of the Fed and other regulators?

PARKINSON: I think the—right now—it gets back to this question of whether they’re resolvable. I think there is skepticism that, at least at this point, that they are, and therefore, an unspoken goal of—I think they’re pretty clear: They wanted to become smaller and simpler. As Ben was saying, we haven’t seen a lot of sign of that thus far. I think those pressures will still be there. How intense they are will, again—I don’t think regulators are going to judge that simply on what their total assets are, and that wouldn’t be a sensible metric I think in any event, but when they go through this living wills process and act, ask themselves, am I confident that if this firm entered bankruptcy, that the financial system would not be disrupted and therefore would not be tempted to bail them out? If they’re not—if they answered to that—if they’re all uncertain about the answer to that question, I think the pressures are going to get more intense. But if they become comfortable—and I think they are at the margin becoming a little bit more comfortable—then perhaps, not such severe effects.

FOULIS: OK, so the jury is still out.


FOULIS: We’re going to turn now to the members for some questions.

STEIL: Patrick?

FOULIS: Oh yeah, sorry, go.

STEIL: Jamie Diamond has said publicly that it’s not his objective to shrink the bank. He’s going to fight against that. With regard to living wills, my personal opinion is that it’s a good exercise to force the banks to go through. Having said that, what you’re getting is really no more in my view than a legal opinion, because these enterprises are so complex that it is very difficult to determine how some government entity overseas, say in Indonesia, is going to react in the case of a subsidiary of a U.S. bank going into some sort crisis mode. Very difficult, certainly for a lawyer sitting in New York, to predict.

Can I just emphasize two areas where I think we are still vulnerable and have not paid nearly enough attention? First of all, taxation. Why do banks insist that equity capital is so much more expensive than debt capital, when theory—the so-called Modigliani-Miller theorem says that companies should be indifferent between debt financing and equity market financing? If you look at the differential on tax rates between the two types of financing, it’s enormous. The CBO did a study a number of years ago, finding that the effective marginal tax rate on debt finance—on equity finance investment in the United States was about 36 percent. Whereas that same tax rate for a debt finance investment was negative 6 percent. It’s very heavily subsidized. And until we deal with that incentive to leverage built into the tax system, we’re going to have tremendous difficulty encouraging banks to use more equity.

The one area we haven’t talked about with regard to vulnerabilities which I still think is quite important is money market fund. We’ve made significant progress on the institutional side. We’ve gotten rid of the fixed net asset value. It’s now floating. So they’re effectively like mutual funds, which is progress. But on the retail side, we haven’t touched anything. And there’s still about $900 billion in U.S. retail money market funds. About half of that, 500 billion (dollars) is in so-called prime funds, which can invest in non-U.S. government securities. And about 40 percent of that is invested in Europe. And much of that is wholesale financing for European banks that become vulnerable every time you start talking about a sovereign debt crisis on the periphery. So I would not be surprised at all if within a year from now we were talking about the whole break the buck issue once again.

FOULIS: OK, good points. Could we start with the gentleman on the right there, please?

Q: Hi. My name is Peter Conti-Brown. I’m a professor at Wharton.

I have a question about fed independence and this lack of regulatory consolidation. So the Fed’s vice chairman, Stan Fischer, gave a lecture last week talking about Fed independence and said it’s possible for one institution to be independent in one ways, namely monetary policy, not independent in others. I wonder if you could talk a little bit about that, given that some of the hallmarks of Fed independence, its budgetary economy, long tenure of governors, the president’s inability to fire members of the board, apply equally to all of the Fed’s functions. So how do we think about Fed independence across these different domains?

PARKINSON: I think it’s a good question. I mean, even looking a slightly different way, obviously the Fed has come in for a lot of criticism because of things it did or didn’t do in the regulatory area. And I think that is one of the things that’s bringing its independence under pressure. So I’ve always thought there is a risk that the Fed’s view that it needs to be involved in all those other things in addition to monetary policy could prove to be a threat to its monetary policy independence.

And I think we’re seeing some evidence of that. And because the strongest arguments, I think, for Fed independence are monetary policy independence. There’s really no argument why it should be more independent than the SEC or the CFTC or anyone else in the regulatory sphere. There is—are good arguments and good empirical evidence, I think globally, that independence is an important thing for monetary policy. So I think you’re right to perceive a certain tension there, and potentially some difficulties down the road.

FOULIS: As a follow-on from that, were we to be in a crisis situation again, do you think the Fed could extend liquidity, which you’ve just argued is relatively benign, to the same degree again without generating a lot of political heat?

PARKINSON: Well, I worry about that. Again, Dodd-Frank only restricted the Fed’s emergency authority, and did it in ways that, at least as I interpret the words, make sense. Again, the Fed created some trouble for itself by providing solace and support to AIG and to Bear under the guise of liquidity support. They did that because no one else had the authority and they thought that was better—even if it wasn’t better for the Fed, it was better for the country, at least in the short run. So it was understandable that they limited that emergency authority.

I’m more worried, though—some of the discussions I hear and criticisms about Fed liquidity actually would suggest it even having a discount window for commercial banks is a bad idea. In fact, I think Tarullo gave a speech about a year ago essentially defending the existence of a lender of last resort. So I think some of the rhetoric, some of the thinking in the Congress and academia has gotten to the point where they’ve forgotten about why we created the Federal Reserve in the first place. This recent book by Roger Lowenstein is, I urge everyone to read it, which will remind you of why we created the Fed in the first place. And it was to provide liquidity support. So I worry about it.

I also worry that from the bank’s point of view we had a problem in the last crisis when the Fed created facilities, the banks didn’t want to use them, because of this perceived stigma that if you borrow from the Fed you are a pariah and lots of both political pressures and perhaps market pressures were going to come to bear on you. If we had a problem in the last crisis with stigma, just think about how much trouble stigma could cause in the next one? And again, if the banks don’t borrow, their alternative at some point is to liquidate assets. And liquidating assets is not good for the real economy.

FOULIS: Annette, do you want to touch on Fed independence talk—an independent view of Fed independence?

NAZARETH: Well, I’m not totally independent. It was married to a Fed governor, so I have to sort of split myself down the middle. (Laughter.) Look, I admire the fact that the Fed has as much independence as it does. I mean, coming from an agency that has become so highly politicized, I think that—you know, I think it’s incredibly important, as Pat said, at least on the monetary side to have the level of independence that they do. I agree with Pat, that they didn’t have a history of being as aggressive on the regulatory side as the securities and futures regulators. But I think that has changed quite a bit now. And so I think they’ve—but nevertheless, I think they’re not held to quite the same accountability on those issues as the other financial regulators.

FOULIS: OK. Let’s see if there’s another question. Bob.

Q: Thanks. Bob Hormats, Kissinger Associates.

I’d like to follow up on the last point Benn made when he was talking about money market funds, and ask him to expand, and if the panel would expand a little bit on this. One of the things I think has not been done, or at least been done effectively, is a greater degree of clarity for the consumer about the risks they are taking when they buy certain sets of assets, money market funds being one of them. I would venture to bet that the average consumer buys these prime funds, has no idea about what you’re talking about, about where that money is invested and the risk of breaking the buck, not because of what happens here, but because of what happens in other markets where they don’t even really know their money has been invested.

The second point is the broader point of liquidity. A lot of these funds run the risk that if there is a liquidity problem the banks are not in as good a position as in the past to buy some of the assets that these funds have on their books. And the broader question of illiquidity I think can have an enormous effect on the consumer. The average consumer of a fund doesn’t know the difference between buying a bond and buying a bond fund—entirely different. What can regulators do—the Fed, SEC, or others, do to provide a greater degree of information transparency, clarity to investors so they understand when they take risks, what the nature of the risk is, what kind of things they’re getting, because the average person in their 401(k), or even if they just buy this stuff form their broker, doesn’t understand it. And the risk in a downturn could be quite substantial, and people would incur risks that they don’t even understand they’re incurring.

STEIL: This is a—this is a great question. When I was, you know, just searching for articles that had been written about this, the reregulation of the money market fund industry, I found this Vanguard document which indicated what these new rules were, that if you were a retail investor you are now presented with gates. In other words, if you want to get out, there’s a 2 percent redemption fee, time limits can be imposed, you might be able to get your money immediately. But as a Vanguard Fund holder, I had no idea about this. So I’m sure they communicated it to me in one of their many emails which go into my spam filter, but I knew nothing about it. And I’m a relatively sophisticated investor. I certainly knew, given the hat I wear, that these things were coming, but I didn’t know about it through the fund itself.

I think the regulators were very concerned about spooking retail investors, when in fact we should be leveling with them that these particular instruments were a danger. And if they’re concerned about never breaking the buck, they understand that concept, that they should put their money in FDIC-insured bank accounts. They should not be putting them in money market funds. These risks that I was talking about before are very material in a zero-interest rate environment. If any of you have money market funds, check the yield on them. They are anywhere from zero to .0001 percent. It’s almost nothing. So just to keep the return above zero in an environment like this, given that the funds have costs, they have to lend money to European banks. That’s the only place where they receive a positive return. If one of them should go into difficulties, we will be faced again with a break the buck crisis. So my view is the only way to address this problem is to eliminate the whole concept of a money market fund as being distinct from a mutual fund in general, with a floating net asset value.


Q: What about the longer-term bond fund issue, the illiquidity issue in the—

STEIL: When you refer to the illiquidity, are you talking about the movement of banks out of market making? Yeah? Well, that’s certainly been one of the effects of Dodd-Frank. We’ve classified this sort of bond trading as being proprietary. So we’re seeking market makers pull out of that particular business. I’m not wholly concerned about this because we are seeing the same sort of effects that we’ve seen in other asset classes when market makers pull back. We’re seeing liquidity providers come in from HFT firms. I know they have a terrible reputation, but some of them are not predatory. They are liquidity providers. And I think that we are seeing them move into the bond space. So I’m—I don’t think that needs to be a crisis, but we should not be giving banks incentives to exist the business when it’s still a buyable service.

FOULIS: Pat, do you want to give a response to that, touching both on the products which may be at risk and also the issue of whether inventories at banks has reduced liquidity?

PARKINSON: Sure. I think—the first thing about liquidity, I think one has to start by distinguishing liquidity from liquidity risk, or liquidity from—in normal times—from liquidity under stress. You know, the regulators thus far claim not to see much evidence that liquidity’s been reduced. And even if they would admit to that, they would say it’s not clear. It’s due to regulation, et cetera. But I think all that may be right, but the real question is when the system becomes under stress in markets that traditionally have relied on bank intermediation for liquidity, will the banks really be able to—be willing to provide that intermediation service?

I think the answer is we can’t possibly know. You know, we see some signs in these sort of flash crash events that—although, some of those were in markets where the banks actually don’t intermediate, so—but that gives rise to concerns that they may not be there when we need them, for understandable reasons. So I think unfortunately it’s one of those areas where if there is a big problem there, we’re not going to learn about it until in some sense it’s too late, or at least we’ve experienced some pain and suffering before we figure out we need to change policy.

NAZARETH: You know, the—obviously the whole issue of money market funds has gotten a lot of attention in the FSOC. And there’s been quite bit of tension between the SEC, which as the primary regulator of that market has, you know, said that they want to really be in charge of the—you know, the rulemakings and whatever reforms are necessary. As you mentioned, Benn, they did come up with the rulemaking that had floating NAB for the institutional funds and the gates, which I know the Fed didn’t like at all. There was no consensus on what was—even that rulemaking seemed like a political compromise. It was a little hard to understand why floating would not apply to retail, since you would think that that would actually impose a discipline and an understanding of the risk of the instrument. But I didn’t have a vote. So—(laughter)—so that’s an issue.

I think it’s pretty clear that Mary Jo White is very concerned about this issue. And I thought it was quite remarkable, in lightning speed compared to other rulemakings, the SEC came out recently with a money market fund or mutual fund modernization proposal, which would basically require substantially more information reporting to the SEC, a lot more transparency on the activities, which presumably, among other things, would put them in a better position to decide exactly what the risks are. I’m not sure they have all the tools at their disposal now. So I think that’s, you know, terribly important. And so I think, you know, we will see some changes. The other thing that Mary Jo White talked about which I thought was quite interesting, was having living wills or stress tests and things like that for the funds as well and, you know, looking to what the bank regulators are doing and borrowing those techniques for the funds. And so I think there’s a lot that needs to be done. I think the question is are they—you know, can they move quickly enough to address the concerns?

FOULIS: Do any of you worry about ETFs? We had that experience in August where the stated price of a lot of these products fell completely out of whack with the underlying—does anyone—are ETFs a symptom of the same problem?

PARKINSON: Well, I think it is—the basic problem is there any reason to think that they could possibly be more liquid than the underlying bonds? And to the extent people think they are, that’s probably delusional. And indeed, we saw some—this is not my area of expertise, but I know there’s a very intense focus on, at least in the equity area, I think more when you have circuit breakers in the underlying market, but not circuit breakers for the exchange-traded funds, does that create some problems you hadn’t anticipated? So the short answer is yes.

NAZARETH: I think that could happen. I think they didn’t anticipate that you had a circuit breaker on the underlying and not on the ETF that you wouldn’t have these wild variations, and that that was, you know, yet another problem that people hadn’t anticipated with some of the new regulations.

FOULIS: OK. Another question. The lady in the middle there.

Q: Hi. Brigid McDermott from IBM.

We talked a little bit about sort of what I would call the strategic inefficiencies of compliance. If we look at executional inefficiencies, we talked about the billions of dollars that the big banks spend, but they’re spending that primarily with headcount, right? So you have 40,000, 50,000 people in a large bank actually executing on this. Does this mean that the smaller banks then who can’t put the same kind of headcount at this and who really can’t share the expertise that the big banks have are in some ways too small to execute on compliance? And we actually—the regulations that are supposed to get rid of “too big to fail” actually get rid of too small to execute on compliance?

STEIL: The regime is very different as between the big banks and the smaller region banks or community banks. So the burden is not commensurate. That’s not to say that there isn’t a burden, and indeed community and regional banks complain about it quite naturally. But it’s not nearly what’s being imposed on the big four.

PARKINSON: Well, they have, as you’re seeing, tried to tailor—I think that’s the word Fed uses—tailor the regulations to the size and complexity of the institutions. And for that reason, many of the burdens imposed on the largest institutions are not imposed on the community banks. But they are quite worrying. I think their fundamental point is that, number one, even if the burdens aren’t as large, they may be less manageable for the community banks. They don’t have the scale. I don’t know how you deny that. And then I know the Fed, like the other supervisors, will worry about so-called trickle down, that even though the—in Washington they decide these regs should only apply to the large ones and not the small ones, eager beaver examiners out in the field sometimes don’t listen to that and get enthusiastic about doing things to the small banks they shouldn’t be doing. And they have various mechanisms to try to identify and discourage that. But they would probably acknowledge they’re not fully effective.

NAZARETH: I think it’s also fair to say there are some regulatory changes that apply across the board and that have discouraged smaller players from coming in. And I think one of the policy goals behind the derivatives legislation was that, you know, we had a small number of very active dealers who controlled the market. And that by doing this regulation you would have more players. But in fact, the cost of implementing the rules is so massive that I don’t think you’ve seen new entrants really much at all. It’s the same players who’ve just now had to build the infrastructure to do what they were doing before.

FOULIS: OK. Good. Another question? The lady.

Q: Hi. Dorothy Sobol, Johns Hopkins SAIS.

I was wondering on the high frequency trading issue, I wonder if you guys could address that issue and the fact that supposedly over half the trading that takes place in our equity markets is done by high frequency traders. And I know there have been some recent moves to try to and regulate and over control this market. And I wonder if you could address that issue a little bit.

FOULIS: OK. So have the computers taken over? Anyone like to take that one? Annette?

NAZARETH: Well, the problem with the term high frequency trading is that, you know, so much of the trading is electronic, you know, what’s high frequency versus not? I certainly think that one of the issues that the SEC is now interested in addressing is that you do have these people who, for lack of a better term, are called high frequency traders, where they trade in rapid-fire over the course of the day and generally end the day flat. So I guess that’s sort of rule of thumb what they’re calling high frequency trading. And you’re right, they represent a very significant portion of the market.

And one of the things that the SEC is looking at is whether not the footprint of a few of those players is so large that should we really be rethinking the distinction between what is trader, which is not a regulated entity, and what is a dealer, that is a regulated entity. And I think the SEC will in fairly short order be coming out with a proposal that will define based on footprint in the market and the amount of activity that a firm engages in, whether or not some of those high frequency traders will have to now register as dealers and be subject to the full panoply or rules.


STEIL: First thing to point out is that this is—whether it’s a problem or not, it’s not part of Dodd-Frank. With regard to high frequency trading, I think it’s important to understand that the problems that Michael Lewis identified, which I believe are absolutely real, are a certain type of high frequency trading, what you might call latency arbitrage. And I should emphasize that that particular issue is very distinct to the United States. And it’s a remnant of a regulatory process in the equity markets in the United States that doesn’t exist in Europe or elsewhere. We have something called the trade-through rule, for example, which essentially forces artificial linkages among exchanges and trading venues that, again, doesn’t exist outside these borders. This gives an artificial incentive for players like this to come into the industry and inflate the percentage of the business done in the United States in the form of what we call HFT. Again, that’s not to say that HFT doesn’t exist elsewhere and won’t become more important, but the type of toxic HFT that we should be concerned about is really fundamentally a U.S. problem and, again, a remnant of the regulatory process, which I don’t think we’re addressing. Now, Annette was at the SEC many years ago when the Reg NMS was put in and so on. You may have a different perspective than I on it.

NAZARETH: No, I think the SEC has been aware of these latency issues since at least 2009. They talked about it in their concept release in 2010 and talked about ways that they could address it, and they haven’t. So I mean, you know, there are—I still there are benefits to having a best price rule, essentially, in the market, but the latency issues are real and there are ways to address them and they have not been addressed.

FOULIS: OK. We’re going to finish up with two nasty questions from me. Actually, if we could have the person at the back there with a hand up, if we could just do this one very quickly, I think there’s one more.

Q: Thank you. I’m a Chinese journalist.

So I’m very curious to know your perspective towards the comparison between the market regulation between China and the United States? During the 2008 financial crisis the Chinese banks are not very effected by the crisis. And people said, it’s the failure of capitalism, or it’s the failure of the West and corporate governance. And some other people also said the reason why Chinese banks can stay, well, it’s not because of the Chinese market regulators, like CSRC or CBRC, more capable than SEC, it’s because the Chinese financial service sector is less developed. So do you think it’s a blessing for Chinese economy or it means a larger potential risk in the future? Thank you.

FOULIS: OK. Obviously, that discussion looks quite different after the last year in China, but what do we have to learn from China on this? Pat?

PARKINSON: I’m not sure. I mean, the—in general, not just in China, but in Asia generally the financial crisis did not have the same effects that it did in the United States or in Europe. I think that really was a result in part of the markets they were operating in, but also in the types of financial services they were providing. We were quite proud of how innovative and cutting-edge our intermediaries were, but that turned out to be the bleeding edge. But I don’t—longer term, I don’t know what to read into that.

FOULIS: OK, and I suspect the answer is we each have something to learn from each other.

Two parting shots, and if you could—each of the panelists, if you could just try and answer reasonably briefly so we can get through these. The first is, is this—Frank-Dodd’s bit of legislation, is it going to be repealed in 2017? Is that a serious risk? Annette, perhaps.

NAZARETH: I don’t think so. I don’t think it’s a serious risk. I wish it were possible—given some of the concerns you’ve heard expressed here—that it could be in some cases slightly refined, because as you know it was—it was passed quite quickly without a lot of bipartisan support. It would be great occasionally to have some things that need fixing that could be fixed. I don’t even have optimism about that. I think there’s a huge concern about reopening it. I think you’d have to have a huge shift in Congress and the White House to have—

FOULIS: So the can of worms argument?

NAZARETH: Right, the can of worms argument. I think it’s—for better or worse, we’re sort of stuck where we are.


PARKINSON: I don’t think it will be repealed. I don’t think it should be repealed. I do think it will be amended, but for the reasons that Annette indicated, even that turns out to be incredibly difficult, the fear that you might start out with a list of amendments that you thought were sensible and you find that what came out of the other side of the sausage making process was something quite different. So I don’t know how we get out of that box in the near term.


STEIL: I think there’s a higher probability than Annette and Pat think perhaps that there will be significant change in Dodd-Frank if President Carson or Trump decides he’s going to sit down with the tea party-dominated Congress to discuss how we get rid of everything that President Obama did, that Dodd-Frank will be part of that. I don’t think there’ll be a global Dodd-Frank repeal act, but I do think if we have a Republican legislature and executive that we will see some significant changes.

FOULIS: I’m sure Mr. Trump will spend a lot of time on third party repo action. (Laughter.) And the last question, again, I suspect Benn has already answered this, but if you look at the system overall, what is the one thing that keeps you up—awake at night? What’s the one thing we’ve not sorted out and is a big problem?

NAZARETH: I think it’s something that we didn’t talk about today at all, which is cybersecurity risk. I think that’s really our biggest risk. I mean, you know, I’m a former market regulator. I worry a lot about the markets functioning and sort of lived through 9/11. And I just really am concerned about some sort of invasion to our financial system electronically and are we really adequately prepared for that? And are we taking appropriate measures to protect ourselves?


PARKINSON: You know, I think cyber is a big issue. I think the other thing is we have done nothing to address the housing finance system, which in some sense was the cause of the crisis. So that’s a worry.


STEIL: For better or for worse, during the crisis the Fed played the role of intervener in the economy in areas which were too politically toxic for the Treasury—for better or for worse. And what concerns me next time is that they clearly won’t be able to do that to the same extent. The Federal Reserve post-Dodd-Frank is arguably by far the least powerful lender of last resort among the major central banks. There are, for example, as Pat has talked about, significant restrictions on lending to nonbanks. Now, that’s fine and well and good, provided the Treasury can do its job on a timely basis. But it’s not clear to me that they are capable of it. So not having the Fed in that role does concern me, because I’m not convinced that the Treasury is able politically to pick up that ball yet.

FOULIS: At the end of that, I feel enlightened but not entirely reassured. (Laughter.) But I’d like to thank our three panelists very much indeed for joining us. Thank you. (Applause.)


This is an uncorrected transcript.

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