Inside Financial Services

This Probably Isn’t What Dodd or Frank Had In Mind

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Bloomberg, on Friday:

When New York-based private-equity firm Veritas Capital picked Jefferies Group LLC this month to manage a $1.4 billion buyout loan, it passed over some much bigger Wall Street firms. Names like Morgan Stanley and Barclays Plc and UBS AG.

Why? Because Jefferies dangled something in front of Veritas that none of the larger rivals could, according to people with knowledge of the matter: The ability to take on higher risk levels in the deal than regulators deem appropriate for the commercial banks they oversee.

Jefferies, a New York-based investment bank, isn’t beholden to those lending guidelines. The losing firms are. [Emph. added]

Another triumph for post-crunch banking regulation! You might be tempted (I know I am) to dismiss all this as just another example of unthinking legislators producing an outcome that’s the 180-degree opposite of what they had in mind when they wrote a given law. In this case, the law is Dodd-Frank, and the result of it has been, rather than a tightening of bank regulation, a steady flow of banking activity out of the banking system altogether, to what finance critics can be counted on to refer to as “the Wild West.”

The result, as I’ve said before, is that the net effect of all this is to make the financial system less stable rather than more so. This is not a good thing. Lightly regulated entities can sometimes be the source of  chaos. The immediate cause of the financial panic, recall, came from the non-bank sector, money market funds, in particular, after the Reserve Primary Fund broke the buck and caused the entire commercial paper market to freeze up. Just ten years before that, Long-Term Capital Management, a lightly regulated hedge fund, was set to cause a full-scale market meltdown before it was bailed out at the government’s instigation by a consortium of Wall Street firms. And do you remember portfolio insurance?

If I were a policymaker, I’d be concerned. On the one hand, the big banks are still huge, and very well-capitalized. On the other hand, certain activities formerly undertaken by the banks have left the system in large measure and are being performed by entities that are beyond tough regulators’ oversight. You will tell me I’m being too nervous, and everything will work out fine. You will be right. Until you’re not.

What do you think? Let me know!

7 Responses to “This Probably Isn’t What Dodd or Frank Had In Mind”

  1. PureDakota

    Oh, well. Seems like anymore unintended consequences outnumber the intended ones.

  2. mike lesse

    scary having lived through those bombs that hit the street. Why are you the only one to bring up this topic?

  3. Jack Praschnik

    The problem with the ‘Too big to fail’ solution is that it tries to solve a problem by using rules. If you truly want to solve this problem, you have to change incentives. So, why don’t we get rid of Dodd-Frank and put bankers’ net worth on the line. Something to the effect of requiring senior bank executives to pledge their personal net worth against being bailed out would change incentives and therefore behavior. Under a ‘real skin in the game’ paradigm, the financial system’s real risk as opposed to measured risk would fall.

  4. PureDakota

    I don’t disagree entirely with the concept. It’s along the lines of what Michael Lewis described for the investment banks in the days when they operated as partnerships rather than as publically-traded corporations. It did tend to have a positive effect on behavior. The problem with it is that it could become difficult to find top-notch executives, and if it applied to directors, it would become virtually impossible to find high quality directors who would be willing to serve under such terms.

  5. etoleary

    Your analysis is fine as far as it goes. What’s missing in the discussion is the fact that commercial banks are a source of funding for the less regulated firms. So in that sense, there’s been no abatement in the risk systemically. I don’t know the Jeffries’ source of funding for this particular deal but big bank funding is common.
    Dodd-Frank is at heart a punitive response by the Congress to the financial excesses of the years leading up to 2008 (the year Lehman collapsed). It’s largely dumb, wrong headed and ineffective in any true “reform” sense. The next Congress should scrap it and start over. And that includes the CFPB.

  6. jsc173

    See if you can find the hearings from a few months ago when Barney Frank was asked if he thought Dodd-Frank needed to be changed, based upon its effect on the financial system and banks in particular.

    Without being specific and (you know Barney is not a man of few words) not offering up many specifics he essentially said, yes, it definitely needs to be “tweaked.”

    You’d think that when the author of a bill that is now generally believed to be part of the problem, not the solution, says it needs reworking Congress could prioritize a rethink and fix the obvious flaws.

    I guess not.

  7. Ken Greenberg

    Barney Frank – half of Dodd-Frank – helped cause the meltdown by disregarding warnings about Fannie Mae and Freddie Mac. The same guy who helped caused the solution, and was clueless about it, helped write the bill, which explains why it, too, is a mess.

    How many people work at the CFPB now? 1,500? And how about that Taj Mahal they’re building with the never ending budget? I’m with etoleary – it needs to be scrapped along with a bunch of other useless federal programs they’re wasting taxpayer dollars on like slugs on treadmills.

    What a mess!

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