Classic strategies used to respond to a financial crisis — such as the Dodd/Frank strategy of delegating vast discretionary power to the financial regulatory agencies — no longer work.
The effect of these strategies is like “rearranging the deck chairs on the Titanic.”
That’s the take of Columbia University School of Law Professor John Coffee.
Coffee was speaking last week at a conference sponsored by Better Markets and George Washington Law School’s Center for Law, Economics & Finance titled “Five Years On, Learning Lehman’s Lessons from the Panic of 2008.”
Coffee was on a panel moderated by Vermont Law Professor Jennifer Taub and included panelists Neil Barofsky, former SIGTARP and author of Bailout, Ted Kaufman, former Senator who also chaired of the Congressional Oversight Committee for TARP, and Professor James Galbraith of the University of Texas.
“Five years later, we now have to realize that we are seeing administrative paralysis,” Coffee said.
“Every administrative agency that has put out a broad rule has had to cut it back, sometimes cutting it back 50 percent or more. The agencies are not only paralyzed, they are inundated. They are unable to meet the pace set by Congress. Beyond that, they are extremely risk averse right now. They are focusing on the trivia rather than the broader issues.”
“At some agencies, like the SEC, they are showing the instinct for the capillary instead of the jugular. That’s because vision is dangerous, vision gets you into trouble. Focus on the narrow, little issues of meeting tomorrow’s deadline.”
“As a result, five years later, for the most part, with some exceptions, we are facing administrative agencies that are rearranging the deck chairs on the Titanic and doing little else,” Coffee said.
“I certainly do recognize that the financial regulatory agencies are staffed by people who are smart, honest and hard working,” Coffee said. “But also they are intimidated, somewhat demoralized, inundated with too much work, and as a result risk averse.”
“Why is this happening? Political scientists could address that better than me. But among the reasons are Citizens United, the new importance of political contributions and the new power of lobbying. There are other factors, but the factor I would stress in terms of the immediate performance of regulatory agencies is that, like Banquo’s ghost, hanging over this whole environment is the DC Circuit which is being read by administrative agencies to mean — even after long and due diligence research, you adopt rules and they may be invalidated based on a very subjective set of criteria — cost benefit analysis — by the DC Circuit.”
Coffee gave three examples to back his analysis — money market funds, credit rating agencies and over the counter derivatives.
“Everyone recognizes that money market funds are the new highest risk factors,” Coffee said. “I’m not predicting their failure. But under circumstances of financial stress, they all could fail. Money market funds have no loss absorbency. They don’t have a capital buffer. They replace savings banks. But unlike savings banks, they do not have capital. There is an incentive to run. It’s rational for investors to be first in line in running. And thus we have a scenario where the money market funds could experience a giant run on the funds.”
“We have seen merely a cosmetic solution — letting net asset value fluctuate,” Coffee said. “That’s no substitute for requiring more capital. We need capital in money market funds. And Europe has just recognized this. Within the past two weeks, Europe has required money market funds to have a three percent capital buffer. This is exactly what the Financial Stability Oversight Council recommended for money market funds.”
On credit rating agencies, Coffee said that “no one at the SEC is willing to take seriously Senator (Al) Franken’s idea or the broader idea that we won’t have true reform unless we shift from the issuer pays model to some form of investor pays or subscriber pays system under which the end users get control of the selection of the rating agency.”
On over the counter derivatives, Coffee said “this is area where AIG failed.”
“The G20 nations agreed that the answer had to be clearinghouses, exchange trading, more margin to eliminate counter-party risk,” Coffee said.
“What has happened? There had been reasonably good rules prescribed. But the industry has outflanked them. The industry has come up with a very shrewd strategy. They call it substituted compliance. Under substituted compliance, if you are in compliance with the host countries rules, you are deemed to be in compliance with the US rules.”
“That means that if you are American financial institution and you conduct your OTC derivatives business, your swaps business, your credit default business offshore, you can play a giant game of regulatory arbitrage under this heading of substituted compliance if the American agency will say that the foreign system is reasonably functionally similar to our own.”
“This is the battle that is being played out now. We don’t know what the outcome will be. But we face the future world in which all of Dodd Frank can be trivialized by an immense game of regulatory arbitrage as major banks move their higher risk activities offshore.”
“And major banks are essentially very mobile institutions. And that nullifies anything that is in Dodd/Frank if substituted compliance lets you take your activities offshore and then engage in higher risks activities based on complying with the local country’s laws.”
“We are seeing regulatory agencies largely outflanked,” Coffee said. “We have to come up with some new strategies. We have to hold the agencies accountable — not just the banks but the agencies. They are tolerating a little too much under the pressure of strong lobbying.”
Coffee seemed not enthusiastic about the possibilities of breaking up the big banks.
“We can’t bet every chip we have on Brown Vitter and breaking up the big banks,” Coffee said. “Provisionally, we have to say that banks have too little capital to survive. The Federal Reserve is quietly considering (requiring the banks) to slow down or cease their dividend payout to shareholders, which will hurt their stock price, in order to accumulate capital and marginally reduce the risk of failure.”
When asked about cities suing the big banks for their excessive risk taking, Coffee said that substituted compliance might block such lawsuits.
“Because the Supreme Court has limited the scope of our of anti-fraud rules to transactions occurring on American shores, many of those financial institutions have learned that if they were today to sell the same transaction to the municipality of Boston or Oakland, if they put the venue of that sale in Europe, they are beyond the fraud rules,” Coffee said. “And this goes back to the problem of extraterritoriality.”
“The Congress did give extraterritorial jurisdiction to the SEC and CFTC and Dodd/Frank but they are not using it,” Coffee said.
“The SEC enthusiastically adopted substituted compliance. The CFTC grudgingly went there partly because they were undercut by the SEC. But on the fraud rules, if you structure the transaction outside the United States, and mobile institutions can go anywhere in the world, you escape the scope of 10b-5 and our anti-fraud rules. So there is still a bleak possibility that they will able to escape litigation in the future.”
“If you can avoid U.S. regulation, U.S. rules on counterparty risk and using clearinghouses and using margin by going off to someplace — the Cayman Islands, Monaco — there always be some country that can profit from regulatory arbitrage — you will make them rich by producing a haven for running high risk financial casinos,”
“The US has some rules not matched anywhere in the world,” Coffee said.
“For example, the Volker Rule is not matched anywhere in the world. If a US bank could avoid the Volker Rule by moving an office to Europe and engaging in proprietary trading in Europe, they have enervated everything Congress sought to do. And that is still to be resolved. We know the CFTC has been resistant to this and I think properly so. Mr. (Gary) Gensler has been a leader here. But the SEC is quite enthusiastic about substituted compliance. And it’s still an unresolved debate. This is exactly the area where greater accountability and sunlight has to be focused on the regulatory agencies themselves.”
Coffee was asked a question by PBS Frontline producer Nick Verbitsky, who said he was working on a documentary about insider trading.
Verbitsky asked about why the SEC had failed to charge high level Wall Street executives and whether it had to do with a “failure of legal imagination.”
“Federal regulatory agencies have shown a great deal of risk aversion and that’s particularly true in the enforcement area,” Coffee said. “As you may have been suggesting, the SEC never sued any officer at Lehman Brothers. That notwithstanding the fact that the bankruptcy examiner for Lehman Brothers, who is also the chairman of Jenner & Block, wrote a 500 page report in which he detailed just what theories could have been pursued.”
“The New York Times last week gave us the detailed account and told us that Mary Schapiro wanted to sue because she knew the public wanted it,” Coffee said. “But enforcement said — no, we are not sure we can make a case. And the Times let on that the enforcement chief was only interested in doing justice.”
“I would point out that the Times let that one pass,” Coffee said. “When the SEC did not sue, the private plaintiffs’ bar did sue. The case went before one of the tougher judges in New York — Judge Lewis Kaplan, who denied the defendants motion to dismiss and said there was plenty of evidence of fraud for this case to go forward. And the defendants settled for $1 billion.”
“This to me is one of those examples where risk aversion dominated what we really want prosecutors to do. A good prosecutor is going to lose some cases. And we’re talking here about civil cases. I don’t believe in willy nilly indicting people. But the SEC should be pursuing its theories. The Lehman story is the story about the 105 repo transactions, which were basically just designed to hide the facts from shareholders and to hide the level of leverage.”