Letter of Credit Forum

On July 21, 2010 president Obama signed the Dodd-Frank bill into law. As a response to the near collapse of the financial system in 2008 this bill attempts the big overhaul of the financial system to prevent similar crises in the future. Tax payers are weary of  'too big to fail' and want more protection from the sort of lending practices that led to the sub-prime
boom and bust. However, the success of Dodd-Frank seems uncertain at best.

Causes ofthe crash

Academics will discuss the reason of the crisis ad nauseam, but the following already has emerged:

• While some individual banks were safe, many of the largest banks in
  the country did not have enough equity to cover their losses. That is when the  government had to use tax-payer money to bail them out.

• Increasing securitization and the use of derivatives fuelled the
  growth of the shadow banking industry, (hedge funds, SIVs, conduits, money funds, monolines, investment banks which are not properly supervised by government agencies) which is now bigger than the
  regular banking industry. Regulators lacked the expertise and the tools
  to understand or deal with problems in this industry

• Banks and other institutions became adept at manipulating the
  patchwork of financial regulators in the US. Between the Federal
  Reserve, the OTS, the OCC, the FDIC, state banking departments, the SEC,
  and the CFTC, nobody was looking at structural problems and acting to
  control them.

What does Dodd-Frank do ?

• The Volcker rule was intended to  limit the ability of banks to engage
  in risky proprietary trading. The proposal specifically prohibits a bank from engaging in proprietary trading that isn't at the behest of its clients, and from owning or investing
  in a hedge fund or private equity fund, as well as limiting the
  liabilities that the largest banks could hold. However, conferees changed the proprietary trading ban to allow banks to
  invest in hedge funds and private equity funds at the request of
  Senator Scott Brown (R-Mass.), whose vote was needed in the Senate to
  pass the bill. Proprietary trading in Treasurys, bonds issued by
  government-backed entities like Fannie Mae and Freddie Mac, as well as
  municipal bonds is also exempted. Thus political maneuvering prevented a real reform. 

• The Consumer Finance Protection Agency was created with the promise
  of simplifying how consumers get credit. The lobbyists managed to drive
  through an exemption for auto loans,
  and got it housed within the Federal Reserve. The agency still has some
  teeth and independence, and its ability to act as a voice for consumers
  depends largely on the effectiveness of its first director.

• The Resolution mechanism gives regulators the ability to seize and
  wind-down any large financial institution. Unfortunately, it doesn’t
  give them any money. If its ever used, the money will come from
  tax-payers, with nothing more than a vaguely worded promise to recoup
  the money

Looking at the list, one asks, whether the heading was chosen correctly or whether it should rather be called:

What does Dodd-Frank NOT do ?

• Fannie Mae and Freddie Mac continue their uncontrolled ways. Tax-payer
  owned and funded, they continue to be huge time-bombs on the
  government’s balance-sheet.

• The bill does not address the thin capitalization of financial institutions. While the
  Basel framework is due to introduce new rules later this year, few experts expect major changes.

• The patch work of regulators will continue and the turf wars will increase in animosity since all agencies will request and receive additional staff and funding to deal with Dodd-Franck. 

Conclusion
Dodd-Frank fails on the big ticket items and will not have a comparable effect as the Glass-Steagal Act, which was the political response to the great depression of 1929.

Some last minute changes are nice. The Durbin Amendment, for example, limits processing fees on debit
card transactions and the expert clause will make ratings firms liable for the quality of their
ratings decisions.

Good news, but not enough to celebrate.