Bankruptcy and finance law scholar David Skeel’s book, The New Financial Deal: Understanding Dodd-Frank and Its (Unintended) Consequences, appeared in late 2010 and remains one of the best general books for understanding the main themes of this massive legislation intended to reform financial services. I’ve read it closely several times (especially when I need to re-fresh my “big picture” sense of what Dodd-Frank sought to do and why it missed), and I posted about the book here at Volokh when it first appeared. I’m truly delighted to see this in-depth review of the book by Todd Zywicki at the Library of Liberty site, “Regulatory Decadence and Dodd-Frank” (h/t Bainbridge). With apologies to Todd, I’m going to take the liberty of commenting on it, out my enthusiasm for both the review and the book.
When I first picked up Skeel’s book, I assumed from the title that it would be a list of the many, many ways in which Dodd-Frank would produce many unintended consequences. I was curious as to whether, if that was the case, the main theme would be to warn regulators from trying to do anything or anyway very much, on the oft-heard cry of Wall Street that there’s no reason to think that regulators can make things better and many reasons to think they will make things worse. Attempts to apply prudential regulation to the financial services sector are hopeless and screw things up more, because the financial markets are always one step ahead of the regulators and can game anything that the regulators dream up.
As a general heuristic for financial market regulation, I am skeptical of this sort of skepticism. It too conveniently fits into Wall Street’s self-interest in taking unregulated risks and then passing losses over the taxpayers with a shrug – hey,no one could have seen it coming and, anyway, we’re smarter than anyone else, so even if you have to bail us out, you couldn’t possibly do better and so it’s okay if we hold you all hostage to our fortunes. The skepticism is both predictable from self-interest, as have often been pointed out. More importantly but less noted, however, it’s a form of skepticism that often seems too general for the actual nitty-gritty regulatory issues at hand. It’s as though someone said, for example, hey, giving into the OTC derivatives players back in the 1990s and exempting them from otherwise unexceptional regulation was not a good idea and likely reasonably obviously not a good idea – and the reply is, well, you can’t possibly know how to regulate derivatives because, you know, we have no way of proving the existence of the external world and for all you know, we might just be living a dream.
I exaggerate, of course. Still , if one stops to examine the level of skepticism brought against pretty straightforward applications of long-standing risk regulation in the traditional banking sector, the skepticism looks far too general to have bite. It looks like an inappropriately general form of skepticism at the level of “how can one ever know anything” brought to bear on areas where, even with plenty of mistakes, we have actually known lots of things and embedded them, however imperfectly, in our prudential regulatory practice. The particularly unhappy corollary of this skepticism is that, if taken seriously, it not only undermines any real ability to engage in prudential regulation of the kind we’ve been doing for generations – it also empowers a weird, flip-side -of-the-coin optimism of the ability of unregulated and highly self-interested players to do it better or at least no less badly than you. And yet we’ve accepted – in the way in which we’ve accepted this since at least Federal deposit insurance – that the risk of loss can’t be put back fully on the private players, so as to force them to prove just how smart they might or might no be. In that case, what’s needed is not intellectual collapse in the face of overly-broad skepticism; what’s needed is traditional regulatory casuistry within a structure of rules that treat like-as-like, adjusting long-standing practices to new situations. It will never work perfectly, but that’s not actually the point.
This background concern motivated my reading of Skeel’s book in 2010 when it first appeared, and I was very pleasantly greeted by a book that was more than just a collection of complaints about Dodd-Frank or skepticism about prudential regulation in general or a bunch of predictions of unanticipated consequences – all of which would be interesting but not very useful to trying to get a handle on this massive legislation as a whole. Todd’s review takes note of The New Financial Regulation‘s ambition to describe the driving purposes of Dodd-Frank, and for those who do financial regulation reform, he captures the big picture of regulatory reform very well:
Skeel observes that “Contrary to rumors that the Dodd-Frank Act is an incoherent mess… [it] has two very clear objectives.” (p. 4) First, Dodd-Frank seeks to reduce the risk of the financial system before the fact by regulating the “shadow banking system,” especially derivatives, which traditionally have been largely unregulated and governed by rules of private contract, rather than traded on exchanges and heavily regulated. The legislation also adopts a variety of mechanisms designed to reduce the risk of financial failure of these institutions in the first place through its new rules supervising the activities of these large financial institutions. He deems the first group of rules (i.e, regulation of derivatives) as the regulation of the “instruments” of the financial world and the second (regulation of large banks) the regulation of the “institutions” of the financial world.
Second, Dodd-Frank seeks to limit the damage after the fact caused to the financial system by the failure of a large, interconnected, so-called “systemically risk” or “too-big-to-fail” institution in order to avoid the perceived Hobson’s choice of modern regulators: on the one hand to bail-out large financial institutions or on the other to allow them to fail and potentially create a contagion effect that will damage the entire financial industry, by creating a new regulatory procedural mechanism for resolving the financial distress of those institutions. Skeel argues that most of the provisions of Dodd-Frank can be seen as being animated by the pursuit of one or both of these objectives.
Only once those objectives – and they are the proper objectives, Skeel says – of regulatory reform are on the table does it add much to talk about why neither of these correct strategic objectives was likely to have been achieved by Dodd-Frank. And why, at the end of 2012, few and little of these objectives appear on track to be achieved, even down the road; it’s not a matter of having more time. Skeel identifies two primary mistakes in the reform architecture of Dodd-Frank:
“The two themes that emerge, repeatedly and unmistakably, from the 2,000 pages of legislation are (1) government partnership with the largest financial institutions and (2) ad hoc interventionism by regulators rather than a more predictable, rules-based response to crisis. Each could dangerously distort American finance, making it more politically charged, less vibrant, and further removed from basic rule-of-law principles than ever before in modern American financial history.” (p. 8 of Skeel)
The first of these, the enshrining of the “too big to fail” institutions in a partnership with the government but in ways that overwhelmingly benefit the private parties and leave government stuck with the risks, is gradually coming to be recognized across the partisan divides. Too early to say, but perhaps there is an emerging view that TBTF was a mistake and needs to be changed, adopting what Skeel interestingly calls a “Brandeisian” approach against Dodd-Frank’s “corporatist” approach of ever-closer union between government and TBTF institutions. The book review describes the difference:
The “corporatist” approach is one in which government and the financial system are essentially interlocked in a symbiotic relationship and the government singles out the largest institutions for special regulatory treatment, making them functionally public utilities. The “Brandeisian” approach, by contrast, is more populist—rather than seeking to regulate and limit the systemic risks associated with large financial institutions, for example, a Brandeisian approach would seek to eliminate systemic risk by breaking up supposedly too-big-to-fail institutions into smaller institutions that would not raise the same risks.
Whether the second Obama term will bring about a fundamental shift toward TBTF institutions can’t be predicted yet, though post-Geithner, there is likely to be greater agreement that this “corporatist” approach is a mistake. Skeel’s second observation, however, has far less agreement or focus, and – because it implicates not just Wall Street bailouts, but the auto industry bailouts – far more partisan rancor. This is the claim that Dodd-Frank enshrines an approach to risk based around ad hoc-ism and unfettered discretion on the part of the regulator, both on the front end (before a crisis) and on the back end (once a crisis is underway). Skeel, as a bankruptcy expert, argues that the existing system of codified law, in the hands of bankruptcy judges, was capable of dealing with both the Wall Street failure of Lehmann and the auto industry, and doing so would have contributed to the stability of the rule of law rather than ad hoc governance. As the review says:
With respect to Lehman, Skeel argues that the government (and others) believed that they learned two lessons: first, the specific claim that bankruptcy was inadequate to deal with the resolution of a large financial firm; but second, that government discretion could not be bound by a rule-based system such as bankruptcy law. Skeel spiritedly criticizes both of these assumptions.
We might ask – should we care, particularly in a crisis? Why shouldn’t government take discretionary actions in a crisis – the situation, so to speak, when the rules are made to be broken – that would protect the system as a whole? It is, as Eric Posner and some others have said, a form of government responding to “emergency” and a “state of exception” that we accept, for example, in certain ways and to certain extents in national security emergencies, so why should systemic risk crises, in particular, be any different? The rule of law need not be limited to simply the rules for normal situations; the rule of law is surely capacious enough to allow for extraordinary discretion in extraordinary emergencies. Skeel believes that the bankruptcy rules are the rules for the emergency, and there’s no good reason to think they were not up to the task.
Moreover, the corollary regime of corporatism, when no longer in crisis, incurs large institutional costs as the combination of TBTF plus unfettered government discretion in dealing with these institutions – and defining them – permeates the system of capital allocation. The competitive advantages conferred by being a TBTF institution combined with the effects of intertwined economic and political rent-seeking results in crony capitalism at its most disturbing place – at the decision-making center of credit and capital.
Skeel’s answer to this is to re-ensrine the existing tools of bankruptcy, identified as a “rules-based system.” This seems to me right, but I’d add that it can’t be taken for granted anymore that the bankruptcy system, and the judges who preside over it, is beyond politics, or at least that it will remain so. It’s a system that is primarily about private parties, on both the debtor and creditor sides, after all. What happens if such a system becomes much more (just because of who comes before it) a system about governments or governmentally connected actors as debtors or creditors, with implications on all sides for taxpayers, is not so clear. Can the law-based neutrality of a system conceived mostly for private parties maintain that neutrality if many of its most important cases are public or quasi-public? Does it start to evolve whole new doctrines that implicitly or explicitly take various public statuses into account? Does Congress alter the system of rules themselves? A wave of municipal bankruptcies, along with the coming wave of public pension fund workouts, might test these propositions.
This is a fine review of a fine book – congratulations to both Todd and Professor Skeel. I read the review and it caused me to take the book down from the shelf again. It is proving to have a long shelf life, which is not often true of books on the financial crisis and resulting regulatory reform. And I, for one, hope that it has a salutary effect on further debates over TBTF in the second Obama term – and most adventitiously if that debate also took up this question of radical discretion, ad hoc-ism, and the erosion of the rules-based system for dealing with failures at the heart of the system of capital allocation.
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