How Wall Street Killed Financial Reform

I’m sure you heard in the news that JP Morgan lost $2 billion in a trades using complex derivatives tied to corporate bond defaults. But didn’t we fix this two years ago when Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act? It seems like JP Morgan’s mistakes should be the first test of Dodd-Frank. The law fails. It’s just lucky that JP Morgan’s trade was stopped before it destroyed the bank.

By coincidence, Matt Taibbi wrote a piece in Rolling Stone about the failings of Dodd-Frank: How Wall Street Killed Financial Reform. I generally find Mr. Taibbi’s take on finance to be a bit over the top, with more hyperbole in a world that lacks the subtle shades of compromise. This article is no different. But he also gets lots of the right points. Dodd-Frank will not result in financial reform.

Taibbi makes five key points.

1. Strangle it in the Womb

Financial reform started off with some great ideas. But they were watered down as the law progressed through the legislative process. For example, Mr. Volker’s simple concept of banning proprietary trading got twisted and poked, allowing broad exemptions. The Consumer Financial Protection Bureau went from being an independent watchdog to an office under the budgetary constraints of the Federal Reserve System.

2. Litigation

The federal regulators will need to contend with courtroom challenges to their regulations, with industry arguing that they go beyond the scope of the legislation or failed to adequately run a cost-benefit analysis of the regulation.

3. If You Can’t Win, Stall

Many sections of the law are experiencing “unforeseen delays.” Taibbi blames Wall Street lobbyists. I blame the law itself. Dodd-Frank deferred much of the implementation to the regulators, meaning they would need to craft new complex regulations and definitions of key terms that are mere sketched out in the law itself. This overloaded the ability of the regulators to produce new regulations. They are tasked with a ten-fold increase in the rule-making agenda. That means the regulators need more staff and the time to get them up to speed. But Congress largely failed to provide the financial support.

4. Bully the Regulators

When Congress is frustrated with a regulator, they just cut funding. Rather than increase the SEC’s budget to allow for the resources to create and implement the new regulations, Republican congressmen tried to cut the Commission’s budget.

5. Pass a Gazillion Loopholes

Congress is moving bills forward to further undercut Dodd-Frank. We saw that with the Rapid passage of the Jumpstart Our Business Startups Act. (I would argue that it undercuts Sarbanes-Oxley, not Dodd-Frank.) As the balance of power in Congress shifts, parts of financial reform become less viable. I think the true test will come a year from now, after the Presidential election. A Romney win and some Republican congressional wins will likely lead to a rapid erosion of Dodd-Frank.

The one point that Taibbi only alludes to is that Congress does not understand the financial markets or the securities laws. I watched some of the Congressional testimony on the JOBS Act. Only a handful of the member of Congress had any idea what was really in the law. Dodd-Frank is even worse. It was a massive law. I would place a wager that no more than 10 members of Congress actually read the whole law before voting on it. Even fewer understood the implications.