Financial Reform's Unfulfilled Promises

The General Accounting Office has issued a report on the progress of the regulatory agencies as they implement the Dodd-Frank Act financial reforms. It is a depressing read. Fewer than half of the 236 rules required by the act have been adopted. There are not even proposed rules that the public can read and comment on for almost a quarter of the required rulemakings. Congress set deadlines for implementation of about two-thirds of the required rules. The regulators missed 89% of those deadlines.

But the scorecard does not tell the whole story. Several of these missing rules are critical to protecting the financial system from another meltdown. The U.S. economy remains at peril because the regulatory process has not worked as it should. Consider that there are no final rules implementing bank leverage and risk-based capital restrictions in connection with the Basel international standards. The financial markets are chronically prone to unexpected crashes and disruptions. But the last line of defense before bailout is the ability of the banks to weather the storm. A key element of the financial crisis was that protection afforded by bank capital reserves was an illusion. Short-term borrowing, like repurchase agreements, can evaporate overnight. And capital invested in risky and illiquid securities may not be available if their value spirals downward.

Money market mutual funds should also keep us up at night. This $2.7 trillion pool of money has become a dominant source of cash investment for corporations, governments and individuals, displacing bank deposits. The funds guarantee that customers can withdraw deposits at 100 cents on the dollar at any time. But there is no FDIC insurance as provided for bank deposits. In 2008, panic set in and a depositor run on the funds ensued. Depositors wanted to get heir money out ahead of others and the liquidation of fund assets created a downward spiral in the liquidation value of fund investments. That threatened a total collapse of the banking system because the largest source of investment for the funds is short-term bank instruments. The banks needed access to that funding. Only a massive Fed intervention saved the day. The regulators are still debating which among several approaches to rules should be adopted to prevent a recurrence of 2008.

And the Volcker Rule, prohibiting banks from risky proprietary trading, remains on the drawing board. It is the joint responsibility of the alphabet soup of bank regulatory agencies shepherded by the Treasury Department, so coordination is an issue. The proposed implementing rule took forever, but it has been out for well over a year.

The GAO has some ideas about what is behind this miserable performance. They cite three factors. First, these rules are complicated and interconnected. For example, the proposed Volcker Rule prompted more than 19,000 comment letters. While that is true, the regulators are supposed to know what the industries they are regulating. The primary agencies that have had to venture into totally uncharted territory are the CFTC, which was handed the previously unregulated $60 trillion per year swap markets, and the entirely new Consumer Financial Protection Bureau. The CFTC has finalized 80% of its required rulemakings and the CFPB is making good progress even though it did not even have a confirmed director until January 2012.

The GAO also comments that the regulators have to co-ordinate with their international counterparts. While that is true, the real dynamic is that the U.S. regulators are leading the way and the Europeans and Asian regulators are following far behind.

Finally, the dozens of deadlines have presented a prioritization challenge.

But the GAO leaves out the most important factor. The financial services lobby is powerful and well-funded. It is painfully obvious that its strategy was to slow the implementation process to a crawl. The first thing it did was to starve the all-important CFTC whose regulations will constrain its immensely profitable derivatives business. The enormously increased jurisdiction of the agency required greater resources, but Congress cut its budget instead.

Industry representatives then took to the courts, recognizing the strategic position of the DC Circuit that reviews regulations and was particularly short on Democratic judges because of confirmation blockage. Critically, the court demanded a much more involved, and useless, cost/benefit analysis by the SEC that has forced that agency into a grinding process. On top of that, the agency is currently deadlocked between Democratic and Republican appointees with the departure of its Chairwoman.

The list goes on and on, but the most important way industry slowed the process was probably its success in getting exception after exception inserted into the statute itself. Every one of them is an opportunity for an oversight hearing or maybe just a call from a member of congress with budgetary power.

Many of the regulators have acted too slowly. But the impressive ability of the financial sector to fight a regulatory war of attrition is the real culprit.