Regulating Wall Street: the Dodd-Frank Act and the new architecture of global finance

Viral Acharya interviewed by Viv Davies, 22 October 2010

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<p><span class="Apple-style-span" style="font-family: Verdana, Arial, Helvetica, sans-serif; font-size: 12px; border-collapse: collapse; color: rgb(17, 17, 17); line-height: 19px; -webkit-border-horizontal-spacing: 1px; -webkit-border-vertical-spacing: 1px; ">
<p style="padding-top: 0px; padding-right: 0px; padding-bottom: 0.5em; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><em>Viv Davies interviews Viral Acharya for Vox</em></p>
<p style="padding-top: 0px; padding-right: 0px; padding-bottom: 0.5em; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><em>October 2010</em></p>
<p style="padding-top: 0px; padding-right: 0px; padding-bottom: 0.5em; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><em>Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5699]</em></p>
</span></p>
<p><strong>Viv Davies:</strong> Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the 13th of October, 2010, and I'm in London talking to Viral Acharya, Professor of Finance at the Stern School of Business in New York, about his recent book titled <em>Regulating Wall Street: The Dodd Frank Act and the New Architecture of Global Finance</em>. I began the interview by asking Viral to outline the main purpose and structure of the book and to explain why he thought it needed to be written.</p>
<p><strong>Professor Viral Acharya:</strong> This is really a collective effort of about 40, I would say, financial economists, finance, accounting, economics, faculty from Stern School of Business at NYU. We wrote a book immediately in the aftermath of Lehman Brothers called <em>Restoring Financial Stability: How to Repair a Failed System</em>. And we think we had a particular view of looking at the financial crisis, and a particular, very specific set of recommendations of how we might want to go about fixing the financial system going forward. This book, <em>Regulating Wall Street</em>, is really sort of the natural next step in the sense that the Dodd Frank Act is presumably going to be one of the most important moments of redefining financial reforms, at least in the United States, if not globally. And our book is really a serious attempt at looking at the act objectively, critically assessing it on a variety of dimensions, highlighting what are its strengths but, importantly, also pointing out the potential weaknesses, and, in a constructive tone, what exactly the prudential regulators might do going forward to safeguard against these weaknesses of the act.</p>
<p>So academics typically tend to write at a fairly high level about financial reforms. I would say, in my view, our effort is quite unique, in the sense that we've taken the sort of high level academic thinking of how we want to regulate externalities and systemic risk. It's a fairly conceptually sound approach that we propose in the book.</p>
<p>But at the same time, the various sections of the book, there are five sections, focusing on, one, the financial architecture; two, how to regulate systemic risk; three, the credit markets; four, the shadow banking; and five, corporate governance, compensation, and accounting.</p>
<p>And across these eighteen chapters in these five sections, I think we have really tried to understand the Dodd Frank Act in great detail first of all, of course, read it in great detail several times, which probably not many have done distill it to its essence and provide our critical assessment.</p>
<p>I would say each chapter, you could view it as an academic contribution. Of course, it's not at the level of an academic publication, but it's a very applied policy perspective. You could look at it purely from a policy perspective if you want, because the research has been written in a way that is really directly relevant to policymakers.</p>
<p>And you could even look at it from a practitioner or a media standpoint, because it really tries to explain both in nuts and bolts as well as, sort of the way I look at it, the bird's eye view as well as the worm's eye view of what's going on and what's likely to happen.</p>
<p><strong>Viv:</strong> So in terms of reforming the American financial system, would you say that the Dodd Frank Act has been a success?</p>
<p><strong>Professor Acharya:</strong> I would say it certainly has its heart in the right place. There are several aspects in the act that are certainly worthy of applause. For the first time, the financial regulations reforms have really accepted that we really ought to be thinking about systemic risk of financial sector, rather than the more micro prudential goal, which has always been about ensuring the stability of an individual financial institution. As this crisis has shown, you could very well think that every single institution is fine. But if they are all extremely correlated and interconnected, the system as a whole might actually be extremely fragile. And I think putting systemic risk as sort of the centerpiece of what the financial reform should be about is a very significant step going forward.</p>
<p>There is a lot to admire in the act as far as the regulation of over the counter derivatives are concerned. Even if these derivatives were not the primary cause of the financial crisis, derivatives have always, in one form or the other, been crucial at critical points of the crisis, because they've always had a certain veil of opacity behind which they have been operating, mainly because of them being over the counter.</p>
<p>I think the Dodd Frank Act, I would say, drives a pretty decent hand at trying to remove that veil, create a certain amount of transparency, not just for regulators but actually for the market participants themselves, has a reasonable objective of moving standardized products to centralized clearinghouses wherever possible, but ensuring that there isn't too much of a leakage through new innovations, etc., that might remain over the counter.</p>
<p>A lot of rules need to be written down in order to make this work. But I would say, overall, the part of the act that focuses on the derivatives represents a very major and a significant step forward. The third thing I would stress is that, by setting up a council of systemic risk, which is going to be represented from different prudential regulators in the United States, and granting them the authority to contain, to give them tools as well as the authority to contain the systemic risk, not just of the traditional banks but also of non banking entities that they deem as systemically important financial institutions, SIFIs as they call it, I would say that's a pretty major step forward.</p>
<p>Throughout the last year of the crisis, Chairman of the Federal Reserve Ben Bernanke, and now Treasury Secretary Timothy Geithner, who was at Federal Reserve before, all along we sort of heard them say, &quot;Oh, we didn't have the authority to actually put these institutions into resolution or liquidation, etc..&quot;</p>
<p>And lastly, coming to this point, I would say it does try to put in place a resolution authority. I can talk a little bit more later on about whether it necessarily gets that right, but at least the idea that we need to have some sort of a plan for winding down these large institutions, passing on some losses to their creditors, is clearly the right way to go.</p>
<p><strong>Viv:</strong> So you'd say that the new Financial Protection Agency helps consumers rather than hurts them, and actually goes some way towards mitigating systemic risk.</p>
<p><strong>Professor Acharya:</strong> Yeah. Our take in the book on Consumer Financial Protection Agency is positive, overall. We are not sure that this is what was the root cause of the crisis, in our view. We think that the root cause was really that the financial institutions were taking on a lot of correlated tail risks, that the housing sector or the economy is going to do fine most of the time, but with a small likelihood, collapse, and we'll all probably fold up all at once at that point. That risk was being taken. It was not appropriately priced, and unfortunately it materialized, and the taxpayers have clearly taken the hit, globally.</p>
<p>However, there are clearly some issues that could be fixed. For example, to the extent that there is often a household propensity to borrow, which is hard to control at an individual household level, to the extent that households may often be somewhat unsophisticated, if too many complex varieties and unnecessary innovations of the basic products are being offered to them. I think there is some room for at least ensuring some plain vanilla products are always offered to them. It provides some sort of financial literacy about some of these products.</p>
<p>And as many have stressed, in Europe, many countries just don't allow mortgages, for example, which are worse than a certain loan to value ratio. I see a lot of merit in something like that. It helps to serve the consumers. At the same time, it guards the systemic risk in the economy by preventing credit booms from just going completely off kilter.</p>
<p>So, if utilized appropriately, I think even the consumer financial protection could become an important part of the overall macro prudential regulation of systemic risk. We are not sure whether it's necessarily the most important piece. We think that there are ways in which the financial sector can undertake systemic risk which need not involve retail consumers at all. You could take a lot of systemic risk by just betting on commercial real estate. You would perhaps argue these are fairly sophisticated players. You could create a lot of systemic risk by allowing another giant hedge fund like Long Term Capital Management to take on excessive risks.</p>
<p>I think, both from a popular standpoint as well as from the standpoint of containing the retail credit boom, the Consumer Financial Protection Agency is attractive. It could serve a useful role, but I don't think it could be the end goal of regulating systemic risk.</p>
<p><strong>Viv:</strong> To what extent do your ideas and recommendations in the book, on risk and capital requirements, etc., differ from what's contained in the recent Basel III proposals?</p>
<p><strong>Professor Acharya:</strong> That's an excellent question, given how much attention Basel III has gotten. Our first and foremost proposals in the book, I would say, on systemic risk are really twofold. One is that the financial sector enjoys a vast number of guarantees. You can think about deposit insurance. You can think about the implicit &quot;too big to fail&quot; guarantees.</p>
<p>You can think about institutions such as money market funds, which, on the face of it, are treated as funds in the United States, so they are regulated by Securities Exchange Commission, but really, when you look at them somewhat closely, they look more like a bank with certain controls over its majority mismatch and so on.</p>
<p>All of these institutions have implicit guarantees. Every time we have a crisis, there are liquidity facilities which are opened up for financial institutions through the central banks, when they serve their lender of last resort function. These are all guarantees. These are options that banks avail of. They anticipate them when they are taking their choices. Their creditors anticipate what these guarantees are when they provide their financing through these institutions at a relatively flat or risk insensitive cost of finance. So all this affects the risk taking that we see being taken in the financial institutions.</p>
<p>I think, first and foremost, governments and prudential regulators need to charge for these guarantees. Most of the time, these guarantees kick in when there is systemic risk because, if an individual institution gets into trouble, you don't really need to start doing lender of last resort. You can manage it pretty well through getting the solvent institutions to coordinate a purchase, breaking up that institution and easily selling off the pieces, perhaps even at a premium, to the solvent institutions at that point.</p>
<p>So, Basel III, and in general the Basel capital requirements we have seen before, they don't really address the fact that different financial systems, different financial institutions have different kinds of access to government guarantees, and that, first and foremost, those need to be paid for.</p>
<p>Then you could come to the Basel view, after having charged for the guarantees, that there needs to be some sort of a cushion, as a buffer against unexpected losses. But again, I would say this buffer should not be thought of just as a safety bank. The idea of charging capital requirements should partly be as an incentive, so that the financial sector actually anticipates that if they undertake certain systemically risky activities, they're going to have to put up more capital against it.</p>
<p>The reason why this incentive view of capital is important is for two reasons: One, it makes it clear that you don't necessarily need to regulate the individual risk of institutions, because that, presumably, the market prices, perhaps what the market doesn't really price well is the systemic risk, because it is linked to externalities and is probably backstopped in expectation by the government and the central banks.</p>
<p>Two, it's important because, when you think about the Basel capital requirements, and when you think about the fact that some classes of assets, such as triple A rated, mortgage backed securities, have been given a 20 percent risk weight, say, relative to a triple A corporate loan, you recognize that the financial sector is going to respond to these incentives. They've suddenly realized that, oh, it's much cheaper for me to make mortgages, repackage them into triple A tranches of mortgage backed securities. And if I do that, I need to put aside a lot less capital, or, in other words, be more leveraged on my balance sheet.</p>
<p>So the incentive view is important, because we have to recognize that once you design the Basel capital requirements, institutions are going to respond to that. Now, in the wake of the current Basel III proposals, an important debate that has come about is whether institutions will simply try to meet the capital requirements by shrinking their balance sheets and keeping the current levels of capital so that they come within the right zone, or will they continue to perform intermediation the way they have been thinking about, but simply expand the buffers of capital that they need for the expanded levels of intermediation.</p>
<p>And I think this sort of debate is very important.</p>
<p>So I would say where we differ from the Basel view, first and foremost, is that it doesn't address the issue of guarantees, and two, it takes very much of a buffer approach to thinking about capital rather than an incentive approach.</p>
<p>What is a big problem with that? The big problem with that is that you had a mortgage lending boom from 2003 to middle of 2007. Banking sector looks wonderfully well capitalized by Basel capital standards. But that's because they have all been loading up on triple A rated tranches of mortgage backed securities, which have been given a capital charge advantage without much thought to the fact that, oh, this might actually completely shift the allocation of financial intermediation, to mortgages, away from corporate loans and other kinds of activities.</p>
<p><strong>Viv:</strong> The US seems to have made more progress than Europe in terms of developing a framework to deal with bank resolution. In a recent major conference in London on regulatory reform, hosted by CEPR, a prominent regulator even suggested that we were light years away from agreeing on an international solution to bank failures. What's your view on this?</p>
<p><strong>Professor Acharya:</strong> Let me talk about the US resolution authority which has been proposed in the Dodd Frank and currently being implemented by FDIC, and then I'll talk a little bit about the international issues that have come to the fore, especially in the last two weeks. On the Dodd Frank Act's recommendations for the resolution authority, the idea is to have what they are calling as an OLA, an Orderly Liquidation Authority, for winding down financial firms, including the non bank financial firms, which traditionally have not come under the remit of the Federal Deposit Insurance Corporation.</p>
<p>The overall view in Dodd Frank is that it explicitly prohibits taxpayer funded bailouts going forward I guess, presumably, unless and until the Treasury is forced to intervene under certain circumstances. What that means is that they are going to try and wipe out the management claims, wipe out the shareholder claims, wipe out the unsecured creditors, secured creditors, to the extent needed to wind down an entity and liquidate its positions.</p>
<p>And in fact, the act says that because it's never really charging the systemically important financial institutions any kind of tax or a levy, there isn't going to be a separate fund for these resolutions. And so, in case the costs of resolution, for whatever reason, exceed the costs of whatever is the recovery from actually winding down the institution so, for whatever reason, you had to support a connected entity that might have fallen under because of failure of one entity--then it says that that cost is going to be recovered by imposing a levy, from that point onwards, on the solvent institutions at that point.</p>
<p>Now, there are several issues here, according to us, and as we explain in the book, that are problematic. One, this approach of orderly liquidation is very much the approach taken by FDIC for small individual banks. You get a bank that's in trouble, or you intervene before it gets into too much trouble, and try to sell it off, if needed, liquidate it piecemeal, find a buyer through an auction, get them to pay the most efficient price, and so on.</p>
<p>Now, this is a very individualistic view of resolving a financial firm. The main trouble when dealing with complex financial institutions is that their largest creditors are actually not entities or agents or households outside of the financial sector; they're typically within the financial sector. They're doing a lot of borrowing from other financial firms. They may be connected to money market funds, who may be providing them repo financing, commercial paper, and so on.</p>
<p>So, when you talk about wiping down an institution's claim holders, you have to worry about the fact that when you are doing that process of liquidating and passing on losses, you are passing on losses to other entities in the system out there. And now it could be that some of those entities get into trouble, which really means that they were probably very correlated to start with, because that other institution didn't have enough capital to really bear this loss. Presumably, it also lost its capital for the same reason that the first entity is getting into trouble.</p>
<p>So now you simultaneously need to worry about the orderly liquidation process for that second entity, and so on.</p>
<p>Let's think about what happened with Lehman Brothers. The Reserve Primary Fund, which had provided a big chunk of Lehman Brothers' commercial paper, took a haircut, and effectively we had a run on the Reserve Primary Fund, a money market fund. That immediately triggered a series of redemptions and withdrawals on a number of other money market funds that were perceived to have similar exposures to relatively risky commercial paper in the financial sector.</p>
<p>So, the Orderly Liquidation Authority may find itself in a situation where several of such orderly liquidations have to happen all at once. Now that is systemic risk, which is the fact that a lot of liquidations may be taking place, but there may be very few buyers in the system out there.</p>
<p>It could mean poor liquidations in the sense of transferring assets over to someone who really doesn't know what best to do with it but they just simply happen to be safe at that point. Two, it could mean severe collapses in asset prices which may have some knock on effects onto others who may be doing market to market, or their creditors might perceive the wealth of their balance sheets based on the wealth of these assets in the market out there, and so on.</p>
<p>Now, typically, in situations like this, what you need often is to buy a little bit of time. You need to give the liquidation process a certain amount of time. Even individual bankruptcies of large corporations sometimes end up taking 12 to 24 months, if it's a large airline or something, because you just have a lot of fleet, lots of different businesses which are part of the overall conglomerate to liquidate.</p>
<p>So, I think this is one important aspect that is somewhat understated in the Dodd Frank Act. I don't think it provides any clear plan as to how to deal with this situation. And what is more, it puts some important brakes on the emergency services that might be needed to buy some time during that liquidation process.</p>
<p>Let me explain. What is the easiest way to actually buy some time for liquidation would be to tell the creditors that I have a conservative valuation of this collateral. Let's say my assessment is 80 cents on the dollar, regardless of when I liquidate the collateral and how much I get for it, I'm going to give you 80 cents for a dollar now. Now you go and continue with your business as normal, while I'm taking over this failed institution into some bridge entity that I'm going to resolve over time.</p>
<p>Now, where would this 80 cents on the dollar come from? Most likely, it has to come either from an explicit resolution fund for which you have collected some money upfront before, or it has to come, basically, as a lender of last resort operation from the central bank.</p>
<p>Now, why the lender of last resort? Because the ideal way to do it would be not to simply pay off this 80 cents on the dollar but treat it simply as a conservative additional payment. Now, if the underlying collateral of the failed entity, when liquidated, produces 90 cents on the dollar, you should transfer that additional 10 cents dollar back as well. But if, for whatever reason, the collateral only fetches 70, then you should have a claw back on that 80 and bring back the 10.</p>
<p>So, as a result, this essentially looks like a liquidity provision or a temporary cash infusion into the banking sector, making it fully clear, though, that they are the ultimate bearers of the liquidation risk, but the system doesn't have to freeze until those liquidation values are actually realized.</p>
<p>Now, the resolution fund is not being put in place, because no taxes are being levied based on systemic risk, etc.. The plan is to collect the taxes ex post. But then, how is the resolution fund going to come in place without taxpayer funds?</p>
<p>So there's a certain amount of internal inconsistency in the Dodd Frank about this.</p>
<p>Second, the Dodd Frank Act, perhaps as a response to the support provided by the Federal Reserve, under its emergency powers of the 13(3) part of the Federal Reserve Act, the Federal Reserve provided support to Bear Stearns, AIG, primarily acting as sort of a stopgap, taking on credit risk on these assets in the process, and not passing on any haircuts. The creditors were made whole in these resolutions.</p>
<p>It doesn't have to necessarily be done that way, but you can see that if you don't have a resolution fund, then you do need the lender of last resort to come in and now provide that emergency liquidity.</p>
<p>But the Dodd Frank actually puts some very important restrictions on the Federal Reserve in doing this. In particular, the part of 13(3) that allows the Federal Reserve to lend, through its discount lender or emergency facilities, to individual non bank institutions is going to be now explicitly removed. That's going to be prohibited.</p>
<p>So what it means, if you have a substantial failure that has the possibility of knock on effects on others, not only do we not have a resolution fund in place, we've actually now prevented the emergency fire services from coming into play. Effectively, it's going to mean that, most likely, a part of the Dodd Frank will have to be rewritten when there's a next crisis and a large institutional failure, because taxpayers are going to have to fund the bailout. They might be able to recoup some of the fund injections that they make.</p>
<p>The second point I would stress on resolution, which is a bit forward looking, is that, as we discussed, a lot of the derivatives are being proposed, the standardized ones, for moving onto a centralized platform. This means we are going to create several new systemically important institutions, which are the clearinghouses and centralized counter parties, or individual swap dealers whose primary function is to just provide clearing services.</p>
<p>Now, what are these entities? Many of them are going to be non banks. Now, they could all set up themselves as a bank, so that they do have access to the Federal Reserve discount window. But then it, once again, sort of goes against the spirit of the Dodd Frank, which was not to support non bank institutions.</p>
<p>In any case, we recommend that clearinghouses have access to lender of last resort from the Federal Reserve. In fact, in the book, we say that without having a credible resolution authority in place, it's not clear that necessarily curbing the rights or the powers of the Federal Reserve to intervene when there's a large institutional failure is necessarily a good thing.</p>
<p>It might look like a terrible thing ex post, but if it were not able to provide the support, we might just see a rerun of Lehman Brothers all over again.</p>
<p><strong>Viv:</strong> What do you consider to be the single, most important issue that should be top of the agenda at the upcoming G20 meetings in Korea?</p>
<p><strong>Professor Acharya:</strong> I think it's extremely important to get some agreement on how we are going to resolve the large, complex financial institutions that have an international presence. It's not just a matter of the FDIC in the United States or the Bank of England in the UK choosing to wind down a large firm. It's clearly going to have knock on effects on financial sectors in other countries. So, they need to have a certain agreement. I think we have a bit of a discord right now, not a full discord, but I would say at least a conceptual discord, where authorities in the UK and Europe are leaning more towards a bail in, or sort of a conversion of debt into equity as a way of buying some time.</p>
<p>The US seems to be going more in the direction of simply having an orderly liquidation process, the way FDIC is used to dealing with banks. However, FDIC does have in place a plan to actually create certain bridge entities, which are only to be liquidated over time.</p>
<p>I think the key question is, when you need to liquidate someone over time, how do you ensure their efficient operation? I think as, just a few days back, Paul Tucker from Bank of England has highlighted that, most likely when you put an institution into liquidation, both its liabilities and assets start running on them, because, for many financial firms, assets are relationships, they are clients and so on.</p>
<p>Would clients want to continue doing business with an entity whose entire purpose is to, basically, liquidate it over the next six months? The relationship is no longer that valuable. Most likely, they will just want to terminate it upfront and switch to someone else. That basically means a liquidation, and a willing liquidation from the assets and the creditors themselves. But if there are some knock on effects, one needs to worry a little bit about that happening too soon.</p>
<p>I think the bail in idea, or the conversion of debt into equity, is a way in which you recognize that the institution is in trouble but, basically, reduce the extent of liabilities or debt that it has, essentially by wiping out equity, but then switching the creditors to be playing the role of equity, the subordinated.</p>
<p>My sense is, probably some sort of hybrid solution might be desirable over here. I think it's a good idea to have a liquidation plan, but you do need to buy time. As I've said before, either you need a resolution fund to buy time, or you need a lender of last resort authority to buy time, or you need something like a bail in procedure to buy time.</p>
<p>Now, I think, at the G20, if possible, they should certainly bring this to the table. The issue is, though, that there's such nuts and bolts of the international regulation that I wonder if it's best discussed by politicians or whether it is best discussed through a meeting of central bankers and the resolution authorities. But I think it's worthy of discussion.</p>
<p><strong>Viv:</strong> Viral Acharya, thank you very much for taking the time to talk to us today.</p>
<p><strong>Professor Acharya:</strong> Sure. Thanks as well, Viv.</p>

Topics:  Financial markets

Tags:  financial reform, financial regulation and macroeconomic policy

Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, published by NYU-Stern and John Wiley & Sons, is available now.

Professor of Finance, Stern School of Business, New York University and Director of the CEPR Financial Economics Programme

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