Wall Street Reform And Consumer Protection – The Foxes are Eating the Chickens

The Dodd-Frank Wall Street Reform and Consumer Protection Act, named for Senator Chris Dodd and Congressman Barney Frank – the two foxes who watched over the henhouses of Fannie Mae and Freddie Mac, helping to kick off the current U.S. financial crisis – was severely criticized by Deutsche Bank this week.  Deutsche is a very profitable international bank.  Criticisms of the financial reform bill include the following:

• Fails to eliminate the risk of “too big to fail.”
• Fannie Mae and Freddie Mac are left intact – we wrote, in an earlier blog, that it could be better for the economy for Fannie and Freddie to be allowed to greatly diminish or disappear.
• Creates 13 new rating agencies, for hedge funds and insurers – most, if not all, with no enforcement power.  Likely, this part of the bill will be spun as a good thing, because it will require the creation of thousands of jobs to run the new agencies.
• Regulators have “broad range” to write rules overseeing banks. On the topic of this license to regulators, Deutsche Bank says “the complexity, ambiguity and timing of substantially higher capital requirements will have a negative impact on lending in the economy.”
• The bill is especially tough on the Big Banks,” and that “most provisions result in significant downward pressure on profitability, upward pressure on capital.”
• Proposes to create clearing houses for derivatives.  Deutsche describes past, failed, attempts to launch similar clearinghouses, including France’s Caisse de Liquidation for sugar trades, shut down in the early 1970s due to unmet margin calls after a plunge in sugar prices; Kuala Lumpur’s commodity clearing house in 1983, which closed as a result of unmet margin calls after a crash in palm oil futures; Hong Kong’s Futures Exchange which shut in the late ‘80s after a government bailout due to unmet margin calls on equity futures.  Also of mention is the U.S.’s Chicago Mercantile Exchange, which “narrowly avoided failure due to unmet margin calls” in the late 1980s.  Deutsche suggests that these clearing houses will concentrate so much risk that a new “too big to fail” entity will be created.
• The new “unwind authority” given to the FDIC  “requires Treasury, FDIC and [the] Federal Reserve to agree a company is in financial distress,” which likely means no quick decisions as officials would have to agree to sign off on a wind-down, potentially creating delays that could hurt creditors and shareholders.
• Invokes the “Volcker Rule” – named after former Federal Reserve chairman Paul Volcker – will hurt bank profits.  Earnings per share will decline, among the biggest banks, by 5% 5o 25%.
• Leaves Fannie Mae, Freddie Mac, and AIG intact and unscathed.

One of the first things a student learns in business school is that when an initiative is conceived, in order to obtain a specific result, it is imperative that a thorough analysis be performed to identify potential unintended consequences.  The unintended consequences may lead to conditions that are worse than conditions before the initiative was implemented.

Deutsche identifies the following potential unintended consequences: 

• Decrease in bank lending; constrains recovery of securitization markets
• Global regulatory arbitrage opportunities
• NY-based Wall Street business becomes less competitive globally
• Drag on U.S. economic recovery
• Less liquidity in key financial markets, including derivatives, foreign exchange and commodities
• Encourages flow of risk and capital to less regulated jurisdictions, either outside the U.S., or in the “shadow” banking system.

In the end, the biggest, unintended consequence,  may be driving the economy back into recession, with ever rising unemployment.  The foxes are no longer just guarding the henhouse, they are eating the chickens.