Notes from the Vault
Larry D. Wall
The Dodd-Frank Wall Street Reform and Consumer Protection Act is a big, complicated piece of legislation. The Dodd-Frank Act (DFA) itself takes 848 pages and requires the regulatory agencies to write 390 rules, according to law firm Davis Polk. Moreover, many of these rules are complicated. For example, to provide a simplified overview of the so-called Volcker Rule (Section 619 of DFA), Davis Polk created a 16-page flow chart and followed that with another seven pages giving a "preliminary overview" of compliance requirements. What sort of process could result in such complicated legislation and rule making? This Notes from the Vault provides a theory of why major pieces of financial regulatory legislation are relatively rare events and discusses the implications for analysts trying to contribute to future financial regulatory policy.1
The difficulty of passing financial regulatory legislation
The U.S. Constitution requires new legislation be approved by a majority vote of both the House of Representatives and the Senate, and then be signed into law by the president.2 Additionally, both the House and Senate have rules that can prevent a vote being taken on a bill even if that bill would otherwise receive a majority of the votes.3 As a result, those dedicated to stopping a bill have numerous avenues for blocking its adoption into law.
Moreover, constituencies that benefit from existing laws and regulations grow as firms and consumers adjust their behavior in response to existing rules. Consequently, some firms and consumers become clear beneficiaries of the current rules, often somewhat indirectly because of their ability to comply with the rules at lower cost than potential new competitors. These beneficiaries have an incentive to use their political influence to block new legislation that might erase their benefits. On the other hand, the winners from new regulations are likely to be diffuse and not necessarily aware they would benefit in the long run. Furthermore, most voters are likely to be uninterested in financial regulatory topics, viewing them as arcane and remote from their day-to-day lives. As a result, new financial legislation, especially major legislation that increases costs for existing firms or decreases safety net benefits, is difficult to pass.4
Prompt passage of wide-ranging financial regulatory legislation
The difficulty of passing new regulatory legislation makes it a rare occurrence but nevertheless new restrictive legislation is sometimes passed. Such legislation tends to be passed in response to a recent scandal or crisis.5 For example, the Sarbanes-Oxley Act of 2002 was passed in response to the Enron and WorldCom accounting scandals; the Dodd-Frank Act in response to the financial crisis.6
Financial scandals and crisis (hereafter, simply crisis) promote the passage of legislation imposing new regulations in a variety of ways. They are typically associated with a visible group of constituencies that were hurt by the crisis and demand a legislative response. Moreover, that demand is likely to be supported by the public. On the other side, those who would typically oppose stricter regulation are less able to do so because they are viewed as politically suspect and they may also have been financially weakened by the crisis.
Thus, the time immediately after a scandal creates a condition favorable to the passage of new legislation. Indeed, it creates pressure to act promptly. Those who argue for delaying legislation until a crisis has been fully assessed risk being accused of being soft on financial misdeeds. Further, those most supportive of new legislation must be concerned that the window of opportunity will close. The public's interest in the topic will likely fade as time passes, and those opposed are likely to regain some of their political strength. Rahm Emanuel, adviser to President Obama, was quoted saying, "You never want a serious crisis to go to waste.… This crisis provides the opportunity for us to do things that you could not do before."
A concern with the need to take prompt action after a crisis is determining which action(s) to take. Congress is typically presented with a menu of actions plausibly related to the underlying causes of the crisis. However, it is often not clear how the various proposed measures would work individually or collectively in practice, or indeed whether any of the measures would have had a significant impact on the crisis at all. Given sufficient time, Congress could pass selective legislation based on a detailed analysis of the crisis and appropriate remedial measures. But given the political pressure for doing something quickly and the limited time for doing almost anything, Congress may elect to take a wide variety of measures with the idea that such measures will likely include the most beneficial reforms.
The Dodd-Frank Act is an example of Congress passing wide-ranging legislation while work on the underlying causes of the crisis was still ongoing. Congress established the Financial Crisis Inquiry Commission in May 2009 to examine the causes of the crisis and the commission issued its Report in January 2011. However, the Dodd-Frank Act was signed into law in July 2010, six months before the report was issued.
The difficulty of passing new regulatory legislation also has important implications for the delegation of rule-making power to the regulatory agencies. The pressure to act quickly gives Congress less time to think through the details of how to implement the stricter regulation, creating an incentive to leave the details to the regulators. Moreover, financial market participants often respond to new rules in ways that are difficult to anticipate ex ante, creating a need for revisions to meet evolving conditions. Given the likely difficulty of passing such revisions through the legislative process, Congress may often find it more effective to give the regulators broad grants of authority that allow the regulatory agencies to make needed revisions without seeking legislative approval.7
An agenda for policy analysts
The above analysis suggests that most of the valuable contributions to regulatory policy are likely to happen before rather than after a crisis. Although the exact flaws that will cause the next crisis are unknown, many weaknesses are apparent well before a crisis hits. Identifying and developing sound policies to resolve these weaknesses may put Congress in a position both to act promptly and with legislation that has more power to strengthen the financial system. In contrast, waiting until after the crisis will leave only a small window for identifying the underlying causes and developing suitable responses. Even if the problem is correctly identified, without existing policy recommendations the need to come up with a solution in a short time frame creates the risk that the solution will solve the immediate problem but do so at the cost of making the overall financial system less stable.
An advantage of developing policy recommendations in advance of the next crisis is that analysts can focus on the implications of different policies rather than just the immediate impact of a policy on one type of risk (and/or on one type of intermediary). Here are four important considerations that should be a part of any policy recommendation:
- A major function of the financial system is to provide essential services to the real economy. Systemic risk arises when the ability of the financial system to provide these services is impaired. Thus, in developing policy recommendations, the focus should be on identifying and maintaining the flow of critical services rather than focusing on the fate of any specific class of institutions.
- A core function of the financial system is to allocate resources based on the risk and return of the investment. A corollary of this is that risk-free finance does not exist. We can, if we want, completely de-risk any set of institutions but that means that the risks will appear somewhere else in the financial system. Thus, an essential part of developing recommendations substantially to reduce or eliminate a type of risk in one set of institutions is to consider where that risk will migrate to within the financial system.
- In evaluating who will ultimately bear risk, the goal should be to have risk end up where it lowers the probability and/or reduces the cost of a systemic crisis. In some cases, this may involve shifting the risk to nonsystemic institutions. However, if that is not possible then at least the risk should go to places where it is visible to the supervisors so that action can be taken to mitigate buildups and respond effectively and efficiently if problems arise.
- The same profit incentive that motivates individuals and institutions to operate efficiently also encourages them to structure their operations in ways that minimize the cost of regulation and maximize the benefits of any government subsidies (including the safety net). Policy analysts should recognize that policy changes will not only induce desired responses but also unintended responses designed to lower regulatory costs and raise safety net subsidies. Analysts are unlikely to anticipate fully all of the responses, but should at least seek to identify and mitigate the more obvious of the unintended responses.8
Larry D. Wall is the executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Paula Tkac for helpful comments on the paper. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail firstname.lastname@example.org.
Kane, Edward J. "Good Intentions and Unintended Evil: The Case against Selective Credit Allocation." Journal of Money, Credit and Banking (1977): 55–69.
Wall, Larry D., and Robert A. Eisenbeis. "Financial Regulatory Structure and the Resolution of Conflicting Goals." Journal of Financial Services Research (1999): 16.2-3: 223–245.
1 An alternative question would be how to reform the process of making financial regulatory policy. However, such a question would necessarily be bound up in a more general discussion of alternative ways of structuring a government and as such would raise issues far beyond the scope of this commentary.
2 Alternatively, a bill may be passed into law over a presidential veto by a two-thirds vote of both the House of Representatives and the Senate.
3 For example, in most cases a bill must first be approved by the committee(s) of jurisdiction in each house and then brought to the floor of each house for a vote. GovTrack reports that in every session since the 93rd Congress (starting January 1973), that about 80 to 90 percent of all bills never receive a vote on the floor, and, indeed, that only between 2 and 7 percent of all bills were enacted into law.
4 Similar problems arise with respect to restructuring the financial regulatory agencies. The high-level supervisory officials of the Task Group on Regulation of Financial Services (1984) pointed to four prior groups' reform recommendations to reform the regulatory structure (Hoover Commission in 1949, Commission on Money Credit and Banking in 1961, the FINE Study by the House Banking Committee in 1975, and the Hunt Commission in 1971). The lack of progress on any of these reports led them to state on page 33 that efforts to consolidate the regulatory agencies "may…not be enactable by Congress." Even with that record the Department of the Treasury issued the "Blueprint for a Modernized Financial Regulatory Structure" in 2008, which again called for a fundamental restructuring of the financial regulatory structure but which has not been adopted.
5 However, important financial regulatory legislation is sometimes passed as a part of bills primarily devoted to other topics. For example, FDIC economists James A. Marino and Rosalind L. Bennett explain that Congress adopted Depositor Preference "to project cost savings to the FDIC and use these projected savings to offset part of the projected U.S. budget deficit."
6 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and Gramm-Leach-Bliley Act are seeming exceptions. The key is that by the time these acts involved reduced regulation and were passed, the old rules no longer delivered identifiable benefits to their primary beneficiaries. The Riegle-Neal Act was enacted after states had largely deregulated interstate banking. The Gramm-Leach-Bliley Act was after the Federal Reserve had reinterpreted the Glass-Steagall Act in a way that allowed commercial banking organizations to become important participants in investment banking markets.
7 Robert Eisenbeis and I (1999) also argued that some technical regulatory issues are better addressed by the supervisory agencies and their specialist staff.