NOVEMBER 1, 2020
BY CONSENSUS, Joel Seligman is America’s historian of Wall Street. He proved that in The Transformation of Wall Street, covering both the highs and lows of finance, the economic forces, and the political battles. Now, in Misalignment, he does it again, but this time extending his scope to cover all the financial markets — banking, insurance, housing finance, securities, and derivatives — and extending his timeline to cover US financial history from Hamilton to Trump.
If you work in the financial sector, you simply have to read this book. But if you do not, why read it? First, there is nothing else like this. It can give you financial literacy in one volume. Second, as with other excellent histories, it is a page-turner, laying out a Tolstoyan saga that cuts across all levels to explain how the participants really saw the events unfolding before them (and who they respected and who they despised).
Because Misalignment is also a detailed policy prescription that offers strong medicine, it seems best to analyze this book in terms of three questions: (1) What caused the 2008 meltdown? (2) Where did the Dodd-Frank Act fall short and why? and (3) Does modernizing the regulatory architecture solve everything?
(1) What Caused the 2008 Meltdown?
For Seligman, the central cause was a regulatory system too fragmented — and, in his words, “too balkanized” — to succeed (or even to act coherently). Few would disagree that regulatory structure played a major causal role. In most other countries with developed financial markets, regulatory structure is organized around either a “single peak” or a “dual peak” model. The advantage of the “single peak” model is that everything is centralized under one roof (generally, the Ministry of Finance), and a uniform policy can be set and enforced. In other countries, a “dual peak” model is preferred, so that consumer protection functions are placed in an independent agency out of a concern that consumer protection tends to be subordinated to prudential regulators’ concerns about protecting bank solvency. (After all, bank regulators do not want consumers bringing class actions that threaten their banks.) Only recently this has become a concern in the United States as well, as Elizabeth Warren fought hard to give her brainchild, the Consumer Financial Protection Bureau (“CFPB”), independence from the Federal Reserve.
Overall, the United States stands markedly apart from this division between one and two peak regulatory structures, as it has 20 or more financial regulators, each independent and intensely motivated to protect its regulatory turf from intrusions by rival agencies. The consequence has been not regulatory peaks, but a maze of regulatory foothills. Worse yet, some industries (such as insurance) are not addressed at all at the federal level, but left to the 50 states (and often inconsistent regulation).
As Seligman points out, this multiplicity of agencies invites regulatory arbitrage, as entrepreneurs design their financial products to fall only under the jurisdiction of the least demanding regulator. His favorite example is that the United States almost uniquely divides the field of securities regulation in two, instructing one agency (the SEC) to regulate securities and another (the Commodity Futures Trading Commission or “CFTC”) to regulate futures and related derivatives. There are historical reasons for this division (once the futures markets only traded agricultural products, but today virtually anything can be traded in either market). So why does this structure that virtually no other country follows persist in the United States (when there have been many proposals to merge the two agencies)? Although logically a merger of the two makes sense, logic is a weak force compared to political finance. Put simply, both political parties have discovered that Congressmen with seats on either of the two Congressional committees that oversee the SEC and the CFTC receive very generous donations from Wall Street and the investment industry. For that reason, two agencies are better than one, and no Congressional committee is willing to surrender the gravy train of donations that a merger would downsize.
As this example illustrates, Seligman’s principal interest is regulatory architecture. As he explains, by the time of the 2008 meltdown, a “shadow banking system” had emerged that paralleled the traditional banking system, but was outside the jurisdiction of the Federal Reserve and the other banking agencies. Good as the SEC has generally been at consumer protection, it was less adept at, or equipped for, prudential supervision, and these “shadow banks” — most notably, Bear Stearns, Lehman Brothers, and Merrill Lynch — were subject only to the SEC’s limited oversight. Predictably, risky activities had migrated to the jurisdiction of the regulator that exercised the most relaxed oversight.
Indeed, the activity that most explains the 2008 meltdown — i.e., the securitization of subprime mortgage loans — was outside all agencies effective jurisdiction because they were initiated by free-standing loan brokers that no one oversaw and were marketed in exempt private placements or overseas offerings that the SEC did not review. This illustrates a second basic problem that also explains much of the 2008 crisis: financial catastrophes usually come from the blind side. No one expected that a dull, usually safe field like home mortgage finance could suddenly turn toxic and render insolvent some of the largest banks in the country. But that happened, and some of the largest banks were both villains and victims in the process.
Seligman has credible answers for both these problems. First, he wants massive regulatory consolidation. Second, he wants to build a think tank into this new agency that can see new issues as they emerge (which regulatory agencies limited to a specific industry will not see). His principal proposal is to create a Federal Regulatory Authority, which would include the heads of the major federal agencies, effectively spanning the federal markets. It would be assisted by an Office of Financial Research that would operate as a research arm to spot new crises. Actually, these steps were intended by the Dodd-Frank Act, but the regulatory harness it adopted was quickly shed by the industry. And there is a lesson here.
(2) Where Did the Dodd-Frank Act Fall Short and Why?
Seligman’s proposals bear considerable resemblance to what the Dodd-Frank Act attempted. In his view, Dodd-Frank’s “most serious error” was its failure to “restructure financial regulation.” Dodd-Frank, as he sees it, created only a “toothless” Financial Stability Oversight Council. He is probably right, but a dozen years after that crisis, it may be even more difficult today to put teeth into agencies long defanged by the industry. This is not to disagree with his goal, but to predict resistance both from the agencies that would be merged and a Congress that would be effectively ceding power.
One area where I agree completely with Seligman is his criticism of the Dodd-Frank Act for its attempt to preclude bailouts. Of course, it was a political necessity at the time to proscribe government bailouts and insist that no bank can be “too big to fail.” But it is also rigid, as it ties the government’s hands exactly when flexibility is most needed. Around the globe, since at least the 1870s and the work of Walter Bagehot, the British economist and journalist, it has been recognized — almost universally — among central banks that their critical role is to act as a “lender of last resort” in a financial crisis. What was collectively repressed by Congress and the public was that the costs of not bailing out an AIG or a Citicorp would likely have left the economy in financial ruins. Bank failures imply panics, and no one can predict when or where the panic will stop. Does this mean that a Lehman Brothers should also have been bailed out? Bluntly, I would say yes, and Seligman seems to favor the same answer, but is less explicit. A bailout could have been accompanied by a sufficiently deliberate humiliation of Lehman’s senior executives that the public’s anger might have been appeased. If Lehman’s senior management had been terminated and their golden parachutes clawed back for fraud, that should have been also sufficient to solve the “moral hazard” problem in bailouts. Finally, if the Department of Justice and SEC had been less timid, there might have been criminal or at least civil enforcement actions to make clear that financial executives did not have immunity.
At the time, the answer given by the Federal Reserve’s staff was that Lehman had insufficient collateral and could not therefore be bailed out. That is a lawyer’s narrow answer, and the real decision-makers were not lawyers. I suspect that the actual reason behind the decision to allow Lehman to fail (as Seligman hints) was more Treasury Secretary Hank Paulson’s fear of being labeled “Mr. Bailout” (a term which had been directed at him after the Treasury had earlier arranged a resolution for Bear Stearns). Interestingly, as Seligman points out, both Secretary Paulson and his successor, Secretary Timothy Geithner, argue in their respective memoirs that they were only taking a preliminary negotiating position to establish leverage in the negotiations over the terms of the eventual bailout. Such memories may be self-serving, but they at least show that the principal actors today realize that the case for bailouts is stronger than they then acknowledged.
Almost unavoidably, we will face this crisis again in the future, and the Dodd-Frank Act now gives the Federal Reserve even less discretion to arrange any bailout. Ultimately, the alternative to a bailout will often be a depression. Some will reply that denying Lehman a bailout took courage, but it was the courage of a Kamikaze pilot.
(3) Does Modernizing the Regulatory Architecture Solve Everything?
Of course not! I doubt that Seligman would claim otherwise. But what else is needed? My first fear is that the regulatory independence and competence that he seeks will mean little once the Barbarians get inside the gates. Arguably, that has now happened at agencies such as the EPA and maybe the FDA. Of course, the criminal law may still pose a deterrent threat, but, as we all remember, no significant senior executive at any bank on Wall Street was prosecuted for anything related to the 2008 meltdown. The SEC did not even sue any executive at Lehman Brothers (and this, even more than their inability to catch Bernie Madoff for over 30 years, was their greatest failure). I will not detour here to discuss what it would take to make white collar criminal prosecutions a credible threat for Wall Street executives (as I have just written a book on this topic), but an adequate deterrent threat is a coequal need to an independent and consolidated regulatory structure.
Let’s conclude by focusing on what most causes financial crime. Unlike the other crimes, it is not uncontrollable anger, lust, or desperation. It is just about money, but in 2008, that motivation was enhanced by an order of magnitude. Reckless decisions were made at, among others, Lehman, Merrill Lynch, and AIG. Why? The unique factor that distinguishes this crisis was the impact of incentive compensation (in the form of stock options and other equity awards). An investment banker who realized that the bottom was falling out of the subprime mortgage market in early 2008 would still have pressed to close two or three more securitizations — because he could earn incentive compensation of $30 million or more. The bottom line is that extreme incentive compensation (particularly at financial institutions) is criminogenic.
But here is the final sad irony: the draftsmen of the Dodd-Frank Act knew this and legislated strong restrictions on incentive compensation. This legislation required federal agencies to adopt rules to implement them. Notwithstanding this need, from 2010 to 2016 under Obama and from 2016 until now under Trump, nothing was done, and the provisions on incentive compensation were first delayed and ultimately ignored. The industry fought ferociously behind the scenes to prevent this provision from being implemented — and they won.
What is the message? Sadly, there is a predictable cycle surrounding regulatory failures that I have elsewhere called the “Regulatory Sine Curve”: after a crisis, white-hot public anger compels Congress to adopt prophylactic rules to restrain and punish the relevant industry. Cagily the industry quietly waits and delays, until several years later it begins to lobby to loosen and unwind those rules (often in the name of facilitating economic growth). The public’s memory proves short (particularly when the rules are inscrutably complex). Thus, for example, Congress passed the Volcker Rule in 2010 to keep banks out of certain risky activities (proprietary trading and hedge funds), but today the Volcker Rule is but a shadow of its former self after lobbyists quietly pruned it.
Could anything stop this Regulatory Sine Curve from constantly repeating? Here is one suggestion: take Seligman’s Financial Regulatory Authority and make its chair not the Secretary of the Treasury, but a publicly recognized figure with a strong reputation for integrity. The only role of its chair would be to fight excessive risk taking. For example, a younger Paul Volcker would have been ideal for this role of “Federal Guardian,” and the person so selected should be removable only for cause. In contrast, the Secretary of the Treasury is always compromised by the fact that the Secretary pulls the lead oar on the president’s economic team and must face constant conflicts that may cause overlooking the potential for excessive risk. The chair of this new super-commission should instead act as a countervailing force, whose key role is to prevent a crash and whose neck would be in the figurative noose if such a crash still occurred. That would give its chair the right incentives.
The truth that the public does not want to hear is that banks are indeed too big to fail. Thus, they must be strongly regulated so they do not take risks that could cause them to fail. Here, the Dodd-Frank Act made a gallant effort, but it has been quietly overcome. Still, a decisive election is approaching, and in its aftermath there may be a brief window where reform is again possible. At such a moment, Seligman’s proposals merit very serious consideration and would clearly improve on the existing regulatory maze. Still, structural reform, while useful, is neither a panacea nor a magic bullet. The financial sector will always require close supervision and will always struggle to escape it.
Professor John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance. Professor Coffee is most recently the author of Corporate Crime and Punishment: The Cost of Underenforcement, published this August by Berrett & Koehler.