Derivatives After Dodd-Frank

On June 28, 2011, in derivatives, Dodd-Frank, by Jon Lewis

The New Financial Deal: Understanding The Dodd-Frank Act and Its (Unintended) Consequences. David Skeel. John Wiley & Sons, Inc. 2011, pp. 220, $34.95 For those individuals who work in financial services, understanding the basic provisions of Dodd-Frank is a necessity. Love it or hate it, no other legislation passed in recent years will have such [...]

The New Financial Deal: Understanding The Dodd-Frank Act and Its (Unintended) Consequences. David Skeel. John Wiley & Sons, Inc. 2011, pp. 220, $34.95

For those individuals who work in financial services, understanding the basic provisions of Dodd-Frank is a necessity. Love it or hate it, no other legislation passed in recent years will have such an indelible impact on the regulation of America’s financial services industry. In The New Financial Deal, David Skeel provides both an overview and a critique of the Dodd-Frank Act and suggests ways in which the legislation could be improved. Skeel, a professor at the University of Pennsylvania Law School with an academic expertise in bankruptcy law, argues that two themes emerge from Dodd-Frank; namely, a corporatist European-style, partnership between the federal government and America’s largest, too-big-to-fail financial institutions and “a system of ad hoc interventions by regulators that are divorced from basic rule-of-law constraints.” Among Skeel’s worries is his assessment that the legislation “invites the government to channel political policy through the big financial institutions by giving regulators sweeping discretion in the enforcement of nearly every aspect of the legislation.” Indeed, government regulators will play an increasingly important role in the financial services industry in the years ahead.


Skeel argues that Dodd-Frank was falsely premised on what he calls “the Lehman myth,” the notion that Lehman Brothers’ bankruptcy caused the financial crisis and that, because of this, regulators needed more tools at their disposal to intervene when a large financial institution fell into distress. Through a judicious use of charts (including one indicating the LIBOR-OIS spread reaction to the Fall 2008 crisis) and persuasive argumentation, he aptly demonstrates that Lehman’s bankruptcy did not precipitate the worst of the financial crisis of 2008. Most significantly, however, is his discussion of the conditions under which Lehman filed for bankruptcy. Skeel contends that, because CEO Richard Fuld and Lehman expected a government bailout, they did not prepare for bankruptcy proceedings. “Given the expectation of a bailout, Fuld and Lehman had little reason to start making plans for an orderly bankruptcy, as they might be expected to do if they viewed bankruptcy as a plausible option.” Skeel is generally correct that Lehman may have misperceived that it would be a recipient of a bailout. Nevertheless, Lehman’s leadership – well paid executives, all – clearly dropped the ball. His argument that, despite the dire circumstances, Lehman’s bankruptcy process has been a general success needs to be counterbalanced by the fact that Harvey R. Miller, the lead bankruptcy attorney for Lehman, wrote the book’s foreword. Miller writes that Skeel’s work “is mandatory reading for all those interested in the financial markets and the global economy.” A reader will have to make up his own mind as to whether Skeel’s analysis of Lehman’s bankruptcy process could have been more objective.


While very critical of the corporatist aspect of Dodd-Frank, Skeel is not unthinkingly critical. He acknowledges that Dodd-Frank has positive attributes. One is in its treatment of derivatives, what he succinctly defines as “simply a contract between two parties whose value is based on changes in an interest rate, a currency, or almost anything else, or the occurrence of a specified event.” Dodd-Frank institutes a framework wherein swaps are to be cleared and traded on an exchange. According to Skeel, the most important innovation in Dodd-Frank with regard to derivatives regulation is the “new clearing requirement that gives the CFTC and SEC the power to require that any category of swaps be cleared.” This means that a third party clearinghouse will “stand behind both parties, guaranteeing each party’s performance to the other.”


For those interested in how best to regulate financial institutions, Skeel’s discussion of how a clearinghouse could itself become a source of systemic risk merits particular attention. Because a clearinghouse failure would be catastrophic, Dodd-Frank gives the Federal Reserve the power to lend to clearinghouses, making the largest clearinghouses entities that they themselves are too-big-to-fail. This raises a significant question that policymakers will need to wrestle with in the years ahead; namely, should the United States allow financial institutions – be they bank holding companies, insurance companies, or clearinghouses – to become so big that their failure poses systemic risk to the national economy? Although Dodd-Frank emphatically does not break up the largest financial institutions into smaller components, a future clearinghouse failure, in which taxpayers would be on the hook for billions or trillions, could reopen a debate on this subject that Dodd-Frank seems to have legislatively settled – for now.


Skeel, who has written a history of American bankruptcy law, not surprisingly, is biased in favor of the bankruptcy process as an alternative to the Dodd-Frank resolution regime. Premising his argument on the notion that Dodd-Frank is here to stay and is unlikely to be legislatively repealed, Skeel makes the case for removing the protections that derivatives and other financial innovations are given in bankruptcy proceedings, wherein they are protected from the automatic stay. He contends that “the special treatment of derivatives is a mistake” and that “[t]reating derivatives the same way as other contracts would give the managers of troubled financial institutions much greater incentives to make adequate preparation for insolvency proceedings, and to use bankruptcy rather than the Dodd-Frank resolution regime.” This proposal, which has been opposed by the International Swaps and Derivatives Association, if implemented, would diminish “the bias towards derivatives-based and repo financing.” It would also be a boon for the bankruptcy bar, particularly those attorneys who would then be able to bill hours for their efforts in winding down failing financial institutions through the court system.


In conclusion, The New Financial Deal is worth reading and ample consideration. Students and those interested in bankruptcy law would particularly benefit from reading Skeel’s work. The greatest weakness of the work is that, at times, the author seems too close to the events of 2008-2009 to be impartial to the personalities who were involved in both implementing the bailouts and drafting Dodd-Frank. His reference to Paulson, Geithner, and Bernanke as “[t]he three musketeers of the financial crisis” seems gratuitous. That said, Skeel has written an engaging study of Dodd-Frank and of the likely future of financial services regulation in the United States.

Jon Lewis (c) 2011

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Too Much or Too Little Regulation?

On June 20, 2011, in Basel, Federal Reserve, monetary policy, by Jon Lewis

New Directions in Financial Services Regulation. Edited by Roger B. Porter, Robert R. Glauber, and Thomas J. Healey. The MIT Press 2011, pp. 227, $35.00 What caused the financial crisis of 2008? Three years after the American financial system teetered on the brink of collapse, analysts and pundits have proffered differing theories as to how [...]

New Directions in Financial Services Regulation. Edited by Roger B. Porter, Robert R. Glauber, and Thomas J. Healey. The MIT Press 2011, pp. 227, $35.00

What caused the financial crisis of 2008? Three years after the American financial system teetered on the brink of collapse, analysts and pundits have proffered differing theories as to how and why the United States just barely avoided a second Great Depression. Fannie Mae and Freddie Mac, the Federal Reserve, and too-big-to-fail, highly leveraged banks have all been cited as bad actors. Others have pointed to the Community Reinvestment Act and the federal government’s naive, albeit well intentioned, effort to support homeownership for individuals with poor credit histories. One scholar has – quite convincingly – cited the impact that the Recourse Rule, an amendment to Basel II Accords, had on incentivizing banks to load up on mortgage-backed securities.

There is little doubt that the multiple causes of the financial crisis of 2008 will be debated for years to come. In fifty years, there will almost certainly be historians who will present conference papers debating the issues that constitute our contemporary history. That said, sometimes those closest to an historical event can provide extremely useful insights as to what precipitated the occurrence in question. On October 15 and 16, 2009, a group of experts gathered at Harvard University’s Mossovar-Rahmani Center for Business and Government for a conference to debate and to discuss the recent financial crisis. New Directions in Financial Services Regulation, edited by two Harvard faculty members and by a Senior Fellow at the Kennedy School, is the result of that conference. The book is divided into roughly three parts; the origins of the crisis, appropriate regulatory modifications, and implementing a fitting regulatory structure. The collection concludes with the text of a keynote speech delivered by Paul Volcker, the former chairman of the Federal Reserve best known for his unyielding – and successful – effort to curtail inflation during the early years of the Reagan Administration.

Although the work as a whole is highly recommended for those interested in exposure to myriad takes on the financial crisis, three essays stand out as particularly thought provoking. In “Origins and Policy Implications of the Crisis,” John B. Taylor contends that his empirical approach to the financial crisis leads to the implication that “the federal government’s actions and interventions caused, prolonged, and worsened the financial crisis.” Taylor, who is a professor at Stanford and was Under Secretary of the Treasury for International Affairs in the George W. Bush Administration, puts the blame on the government rather than on the markets. He points to the role played by counterparty risk in the summer of 2007, when interest-rate spreads shot up precipitously. One wishes, however, that he had provided slightly more data and analysis explaining why counterparty risk was the culprit in the unusual interest-rate spreads in the money markets.

Taylor’s main argument is that the federal government failed in its response to the crisis. The government, in his view, failed to articulate a “clear and balanced plan.” Furthermore, he states that, “we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economy theory went wrong; rather, it occurred because policy went wrong, because policy makers stopped paying attention to sound economic principles.” Given his diagnosis of the problem, it is not surprising that his policy prescription would focus “on proposals to stop systemically risky government actions.” Taylor writes positively of new legislation that would ensure that a more accountable and transparent Federal Reserve focused “on the instruments of monetary policy.” At a more general level, he advocates, “government should set clear rules, stop changing them during the game, and enforce them” and correctly posits that, “the rule of law is essential.” Indeed, it can be argued that although government bailouts may have been necessary to prevent a wider economic collapse, they (the auto bailouts, in particular) may have also damaged the rule of law.

In “Underlying Causes of the Financial Crisis of 2008-2009,” Judge Richard A. Posner, of the Seventh Circuit Court of Appeals, argues that “[t]he financial crisis was at root a failure of monetary policy.” He makes the case that low interest rates helped precipitate a housing bubble; however, he specifically does not place the blame on bankers and homebuyers for the banking sector’s collapse. Posner contends that compensation practices, the derivatives market, structured finance, and the GSEs (government-sponsored enterprises) were secondary factors. Significantly, his discussion of how changes in the federal funds rate affect other interest rates merits close attention. What makes Posner’s somewhat lengthy essay stand out is his discussion of the collapse of the commercial paper market. Far too few commentators have devoted adequate attention to this very important component within the broader narrative of the financial crisis; sadly, many would-be experts on the crisis probably have little notion as to what commercial paper actually is. Many readers would disagree with Posner’s bold contention that the government’s failure to save Lehman Brothers was, in his words, “a critical error.” That said, even skeptics of government bailouts would be well advised to read his contribution to New Directions in Financial Services Regulation.

David A. Moss, in “An Ounce of Prevention: Financial Regulation, Moral Hazard, and the End of ‘Too Big to Fail’,” makes the case that deregulation and a crisis of too-big-to-fail institutions are to blame. Moss, a professor at Harvard Business School, cites the moral hazard problem heightened by implicit federal guarantees of systemically important financial institutions. His preferred solution to a clearly articulated problem, however, is not one that all free market advocates would accept as reasonable. While he rightly acknowledges the problem of regulatory capture, Moss nevertheless advocates the creation of a new regulatory agency, a Systemic Risk Review Board. It is not clear, however, why a new agency would succeed where others have clearly failed. Nevertheless, he is correct to note that “implicit guarantees don’t disappear on their own and cannot be ignored or denied into oblivion.” This point is particularly salient, one that policymakers in federal agencies and those on the Hill should take seriously.

In conclusion, Taylor, Posner, and Moss each provide thoughtful, highly readable commentaries on the recent financial crisis, of which yet much remains to be written. Indeed, it is unlikely that there will be a general consensus any time soon as to what caused the meltdown of the financial sector in 2008. This is not necessarily a bad thing. Furthermore, it appears that, as of this writing, the United States is facing a new type of financial crisis. This time the crisis stems from sovereign debt and a huge deficit, rather than from the banking sector, per se. Much will be written on this topic in the years ahead. Those interested in banking crisis of the past few years, however, would benefit from a close read of the essays in New Directions in Financial Services. For individuals unfamiliar with the commercial paper market, Posner’s essay is particularly illuminating.
Jon Lewis (c) 2011


EU Insurance Regulation

On June 8, 2011, in Basel, insurance regulation, Solvency II, by Jon Lewis

Executive’s Guide to Solvency II. David Buckham, Jason Wahl, and Stuart Rose. John Wiley & Sons 2011, pp.194, $95.00 In the United States, the states, rather than the federal government, are primarily responsible for regulating the insurance industry and the business of insurance. This is due to both longstanding custom and, most significantly, to Congress’ [...]

Executive’s Guide to Solvency II. David Buckham, Jason Wahl, and Stuart Rose. John Wiley & Sons 2011, pp.194, $95.00

In the United States, the states, rather than the federal government, are primarily responsible for regulating the insurance industry and the business of insurance. This is due to both longstanding custom and, most significantly, to Congress’ passage of the McCarren-Ferguson Act in 1945. McCarren-Ferguson established a regulatory system in which, unless Congress specifically indicated otherwise, the states were to be the primary regulators of insurance companies. This is why, to this day, each state and territory has its own insurance commissioner; unfortunately, there is no federal insurance regulatory agency in Washington D.C. to oversee and to regulate a national insurance market. Indeed, for a modern economy with a large financial services industry, the American insurance market is quite decentralized.

By way of contrast, the European Union (EU) is in the process of harmonizing its system of insurance regulation to prepare for the challenges of the 21st-century economy. Beginning January 1, 2013, the EU will implement Solvency II, an initiative designed to replace the Solvency I, a reform that the European Commission and European Council agreed to in 2002. In Executive’s Guide to Solvency II, the authors argue that those cynical about this new phase in EU insurance regulation are wrong and that “Solvency II is a well-thought out directive, painstakingly developed over many years by collaboration between the European Commission, member states, and the insurance industry.” Buckham and Wahl, of Monocle Solutions, and Rose, of SAS Institute, have written a comprehensive overview of the Solvency II Directive in a book that will most likely be a standard reference guide for years to come.

The authors begin their work with a cursory introduction to the role that insurance fills in mitigating and transferring risk. For those unfamiliar with the historical development of insurance and its importance in market economies, Chapter 1 is particularly worth reading. The authors rightly note that “the optimal goal” of Solvency II and similar regulations “is to promote a socially optimal balance between the profit motive of organizations and individuals’ rights” and cite Article 27 of the Solvency II Directive which emphasizes that “[t]he main objective of (re)insurance regulation and supervision is adequate policyholder protection.” In Chapter 3, the authors argue, “the important role that insurance companies play in the financial system today makes it imperative that the industry should be regulated.”

As with any regulatory system for financial products, the question is where to strike the appropriate balance between consumer protection, managing systemic risk, and allowing companies to compete and to innovate. (Indeed, the ongoing debate over the how best to write and to implement regulations for the recently enacted Dodd-Frank reform legislation highlights this tension). Significantly, the authors state with clarity “that the production cycle in insurance is inverted; that is, insurers receive a premium up front but are obliged to pay out only if the risk materializes at some future date.” Because an insurer bankruptcy would expose both policyholders and the beneficiaries of insurance contracts to losses, insurance regulation focuses on solvency. That said, according to the authors, insurer insolvency is not very frequent.

For those readers most interested in the nuts and bolts of Solvency II, Chapter 5 provides a useful overview of the Directive. The authors point out that Solvency II, like the Basel II banking regulations, has a three-pillar structure and that its “primary objective is the protection of policyholders and beneficiaries.” What makes Solvency II unique is that it is principles-based, rather than rules-based, and that “it explicitly states that capital is not the only (or necessarily the best) way to mitigate failure.” In the United States, by way of contrast, the states utilize a rules-based system for financial regulation, in which insurers have specific regulations with which they have to comply. Within the Solvency II framework, EU (and Norwegian, Liechtensteinian, and Icelandic) insurance companies “will be required to meet regulatory principles rather than rules.” Under the Solvency II regulations, good governance of insurance companies is emphasized and insurers are given wide latitude to develop internal modeling systems. The new rules “will inevitably shift business attitude from a compliance-based culture to a risk management culture.” What will be interesting to watch is how competitive EU insurance companies will likely be under this principles-based system.

Should Solvency II prove to be a successful regulatory framework for EU insurers, it would likely further expose the weaknesses of America’s current rules-based, compliance-oriented insurance regulation. For those policymakers and legislative staffers interested in modernizing insurance regulation in the United States, Solvency II, as noted by insurance regulation scholars, Martin F. Grace and Robert W. Klein, “could be used as a template, but U.S. regulators need not mimic any particular system to create the best possible system.” That said, for those interested in harmonizing and streamlining insurance regulation in the United States so as to make American insurers more competitive, the Solvency II Directive is worth ample consideration.

In conclusion, Executive’s Guide to Solvency II is not for the general reader, nor is it for readers without a serious interest in the economic and policy aspects of insurance regulation. For individuals working in the EU insurance industry, this book will be invaluable; for Americans interested in bold thinking about how the United States might want to restructure insurance regulation after Dodd-Frank, as well as for those interested in an Optional Federal Charter, this book — and Chapter 5, in particular — is worth reading. It may very well come to pass that by the end of 2013 EU insurers will be far more competitive globally than American insurers.
Jon Lewis © 2011

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Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL

On June 2, 2011, in executive compensation, by Jon Lewis

Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL. Roger L. Martin. Harvard Business Review Press 2011, 251 pp. $24.95 Critics have blamed the financial crisis of 2007-09 on everything from greedy bankers and the deregulation of the financial sector to the policy of encouraging homeownership at all costs, even to [...]

Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL. Roger L. Martin. Harvard Business Review Press 2011, 251 pp. $24.95

Critics have blamed the financial crisis of 2007-09 on everything from greedy bankers and the deregulation of the financial sector to the policy of encouraging homeownership at all costs, even to people with poor credit histories and with little realistic hopes of ever paying off their mortgages. In Fixing the Game, Roger L. Martin, dean of the Rotman School of Management at the University of Toronto, argues that merely scapegoating bad actors misses the big picture. Instead, he contends that at root of the 2008 crash is a systemic problem in American capitalism. He boldly contends that we must rethink the “theories that underpin American capitalism. Our theories about the fundamental goal of corporations about the fundamental goal of corporations and the optimal structure of executive compensation are fatally flawed and have created stock market upheavals.” To solve the financial crisis, argues Martin in this somewhat quixotic book, we must look to the National Football League (NFL).

Martin’s main – and radical – argument is that American capitalism should reject the prevailing business theory, famously enunciated by Jensen and Meckling in their seminal 1976 paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” that “the singular goal of a company should be to maximize the return to shareholders.” Indeed, Martin argues that “[w]e must eliminate stock-based incentive compensation and create new models that focus executives on real and meaningful goals.” To argue his point, Martin repeatedly contrasts the real market, where factories are built, goods are produced, and expenses are paid, with the expectations market, “the world in which shares in companies are traded between investors – in other words, the stock market.” Martin believes that the post-1976 shift to executive stock-based compensation, or compensation based in the expectations market, has been detrimental for American business. In American business today, CEOs are compensated not based simply on their performance in the real market, but by their ability to raise expectations; i.e., to raise the stock price. This, he argues, is problematic. It gives executives an incentive to leave or retire when expectations are high. At worst, stock-based compensation is to blame for the post-1976 dramatic “incidence of large-scale accounting fraud by public companies.” This last point, while intriguing, is very debatable and merits further empirical study.

If the problem is stock-based executive compensation, wherein lies the solution? Martin’s answer: football, America’s most widely viewed and most profitable professional sport. While he acknowledges that the NFL “isn’t a perfect metaphor for business,” he does contend, however, that American business has a lot to learn from how “the NFL managed the division between the real and expectations market in a manner that is exactly the opposite way we have managed it in business.” In Martin’s view, the NFL’s real market is the actual game itself when two teams compete on the gridiron. The NFL’s expectations market is gambling, wherein Las Vegas bookmakers balance the bets on both sides through the point spread. In a provocative comment surely to perplex those who would argue that investing in the stock market is different from betting on Tampa Bay, Martin states that “[t]he point spread in football is the analog to a stock price in business.” Martin correctly notes that quarterbacks aren’t based upon their performance vis-à-vis the point spread. Indeed, we would find such a compensation system to be unworkable. Martin’s point, however, is that American CEOs, in contrast with quarterbacks, are compensated against expectations. “The problem is, in American capitalism, CEOs are compensated directly and explicitly on how they perform against the point spread; that is, against expectations.”

Martin’s argument, while certainly thought-provoking, ultimately fails to persuade. First, the NFL is such a distinct and unique entity in American business that it is hardly a workable model for much of anything else. One need not be an ardent proponent of the free market to be skeptical of an organization that has instituted a salary cap, a revenue sharing agreement among winners and losers, and a free agency system that has no analog in the American labor market. Free market advocates would rightly bristle at Martin’s contention that “American capitalism needs the moral equivalent of an NFL commissioner to weed out existing incursions of the expectations market into the real market—like the safe harbor provision and FASB 142—and to guard against any new attempted incursions.” Outside of the realm of professional sports, however, the NFL commissioner would be something more akin to a Soviet commissar than a presidentially appointed agency head accountable to Congress.

Furthermore, while the NFL is to be commended for its ultimate objective of creating a good product for the fans, namely competitive games that are enjoyable to watch, the League is not afraid to play, for lack of a better term, hardball when it comes to its finances. Witness the NFL’s spurious –and unsuccessful – attempt in the American Needle case to persuade the Supreme Court that it should be considered a single entity for antitrust purposes. Furthermore, the ongoing labor unrest and the legal squabbling between owners and players hardly make the NFL worth emulating. Working American families have little sympathy for millionaire owners and millionaire players arguing over who gets a larger slice of what is a very large pie.
In conclusion, Fixing the Game is thought provoking and worth consideration by those interested in the regulation (or deregulation, as the case may be) of executive compensation. That said, the chances that American business will readily adopt Martin’s NFL model are extremely slim. Any attempt by Congress or regulators to impose such a model on American business would be anathema to the free enterprise system. Stock-based executive compensation may be flawed. There might be a better way of paying CEOs, but that is for individual companies to decide on their own. The NFL’s business model works well enough for the NFL.
Review by Jon Lewis © 2011

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