Academic

Here are a few big-picture questions, I?d like to ask the Masters in the Forum

• What?s the most sensible part of the legislation?
• What?s the worst part? What is the most useless or counterproductive piece of the mammoth bill?
• What?s missing?
• What?s the most likely to end up being litigated or struck down by the courts? It may take a while (the PCAOB litigation wound its way to the Supreme Court for years while another crisis percolated), but which part of Dodd-Frank is most likely to end up before the Supremes? Will that piece be struck down?

Let me take a stab at the third question. There is a tendency in financial reform to fight the last war and this time is no different. But how likely is it that the next crisis will involve subprime mortgages and credit derivatives? Instead of building Maginot lines in our financial legislation, we should be thinking about the next crisis.

Leverage and the parallels to other crises

If one looks, though, with the right level of abstraction, this crisis does have deep parallels to other crises. Taking a comparative perspective, Europe would have suffered its own financial crisis even if no German bank or Norwegian village had purchased mortgage-backed securities. Indeed, Europe suffered a real estate bubble that stretched from the Baltic to the Balkans and many places to the west too. We can also take a historical perspective and draw parallels to many asset price bubbles over 300 years.

The factors that tie these global and historical episodes to our own is not only a wave of inexperienced first-time investors, but, moreover, a marked increase in credit and leverage ? on the part of both households and financial institutions. It?s this increase in credit and leverage that explains the most pernicious effects of subprime mortgages, mortgage-backed securities and cdos. I argued in an earlier post that this was also the most troublesome aspect of credit derivatives ? the ability to increase credit, leverage, and the effective money supply in the entire financial system.

Are lawyers and financial reform laws even necessary?

A number of economists have done critical work hitting on the importance of leverage in the current crisis, including:

• constructing a model of a leverage cycle (see Geanakoplos),
• providing empirical evidence that financial institutions take on leverage procyclically (that is increasing leverage as markets boom and decreasing leverage as markets contract; see Adrian and Shin); and
• describing how ?shadow banking? ? the web of securitization and credit derivatives that connected mortgage borrowers, assorted financial institutions, and capital markets ? provided an alternative credit channel and a means to produce leverage that bypassed the more regulated borrower-bank-depositor chain.

One reading of this economic literature might be that laws and even financial reform is more of a sideshow to getting macroeconomic policy right. This would be a more sophisticated corollary to the story that goes: ?the real culprit in the financial crisis was Alan Greenspan keeping interest rates too low for too long.?   In this reading, what the Federal Reserve really needs to do is get better information on system wide leverage (perhaps by a broader gauge of the money supply) and manage the money supply and cap that leverage accordingly.

There are a number of problems with this type of macro approach which would leave the legal/regulatory picture in more soft-focus, including that:

• Monetary policy remains a blunt and inexact tool. Faulting Greenspan?s monetary policy doesn?t address the fact that central bankers face some pretty dicey choices with using this tool. Regulations can have a huge impact on leverage and the supply of credit.
• Financial regulations impact system-wide credit and leverage.  Changes to regulations like bank capital and reserve requirements and regulations that lose effectiveness can have consequences ? often huge and unintended -- of increasing system wide credit and leverage.
• Figuring out how to cap leverage is easier said than done. As David noted in an earlier post, the Basel Committee is looking at proposals for harder leverage caps to complement traditional capital requirements.
• Rules will inevitably be gamed. In fact the shadow banking system ? from subprime mortgages to securitization to credit derivatives ? is largely a creature of regulatory arbitrage, including the arbitrage of accounting rules. I

In essence, I am saying that, even in a macroeconomic approach, rules matter, figuring out how rules can be gamed matters, figuring out the incentives to game rules matters, and lawyers matter.

What?s missing from Dodd-Frank?   A Donut with Two Big Holes.

All of this is a very circular way of addressing my original question of what?s missing from Dodd-Frank. The bill does address leverage in a number of ways. For example, there are provisions requiring large banks to increase capital (although this strikes me as the wrong part of the cycle to do this). Requiring OTC derivatives to move to changes might clamp down on the leverage created by credit derivatives ? but only obliquely (that wasn?t the real purpose of the clearing proposal) and weakly (anyone want to bet just how many contracts will move to a clearinghouse as a result of the bill?).

But the role of the shadow banking system in the crisis points to two bigger issues that are not adequately addressed in the bill:

Accounting: to regulate leverage and credit requires that we have an effective metrics for measuring leverage. That means looking at balance sheets, which means having a good command of accounting rules. But again, shadow banking and securitization reflected a gamesmanship of accounting rules with echoes to some of the off-balance sheet shenanigans of the Enron era. Dodd-Frank doesn?t begin to address the off-balance sheet problem adequately. Do you trust FASB to come up with the right answer? Unfortunately, most of the accounting debate with respect to the crisis focuses only on the role of mark-to-market.  (Maybe it is time to turn on the Bat-Signal and get Larry Cunningham to come to the rescue). 

The Incentives of Regulators: To stop fighting the last war and start preparing for the next one, we need to start thinking about the capacities and incentives of financial regulators to deal with financial innovation and regulatory arbitrage. Wall Street will continue to invent new products that shift risk, extend credit, and generate leverage. I?ve said this before: the great unsolved problem of financial reform is not ?what new duties and powers do regulators need?? but ?how do we get regulators to do the jobs they already have??