Some in the institutional investment community might have a meltdown over prospects of the Trump administration dismantling the Dodd-Frank Wall Street Reform and Consumer Protection Act, but they should calm down.
No law is perfect, and six years after its enactment is a good time to review and revise and even scrap parts of Dodd-Frank and its related regulations.
The law, enacted in 2010, was the centerpiece of congressional efforts backed by institutional investors, including the Council of Institutional Investors, to stabilize the markets following the financial crisis of 2008, and to try to prevent a similar breakdown in the future.
Asset owners and other institutional investors often talk about smart regulation, but at 880 pages Dodd-Frank overreached, creating overly complex and costly requirements and restrictions.
With the new administration taking shape, now is the time for institutional investors on all sides of the issue to begin to push for smart regulation during a re-evaluation of the law. They are on the frontlines in the markets dealing with its challenges, including lack of liquidity in parts of the fixed-income market, and efforts to label money management firms as systemically important financial institutions, even though they were not the cause of the financial crisis, nor did they play a significant role in it. They should underscore for the Trump administration elements of the law that have been useful, what elements are harmful, and those that need refinement to make them effective.
An outreach would open a channel to influence the new administration, which during the presidential campaign capitalized on an appeal to populism, and identifying with the working class. It might welcome consultation and feedback from asset owners and other institutional investors, who are involved more than any segment of the economy in investing and providing capital for economic growth. Such contact could serve to open a more permanent channel to further dialogue with the administration, helping it shape changes in other existing financial regulations as well as policy on issues that will arise in the markets over the next four years, including climate-related investment issues.
Dodd-Frank was the product of opportunism exploiting fear, with congressional leaders including in the law activities unrelated to the financial crisis. Asset owners and other institutional investors, as responsible fiduciaries, were concerned over the exposure of their funds to the downfall of investments in the housing market, including mortgage-backed securities, credit default swaps, and the counterparty and other risks with the collapse of Bear Stearns Cos. Inc. and Lehman Brothers Holdings Inc., and troubles with banks like Wachovia Corp. and insurance companies like American International Group Inc. There was a breakdown in confidence in institutions from credit-rating firms to the Federal Reserve Board of Governors. The inability of a money market fund to meet withdrawal demands created anxiety among investors in general money market funds, a keystone of stability and safety, leading to a support program by the Department of the Treasury.
During the financial crisis, the actions of some sophisticated institutional investors appeared to be driven by impulse. The California Public Employees' Retirement System and the California State Teachers' Retirement System suspended lending securities to some major financial institutions to lessen short selling and damage to market value. The Securities and Exchange Commission ordered a suspension of short selling in financial stocks to bolster investor confidence. The actions took away temporarily a source of market liquidity and a mechanism to challenge valuations.
Asset owners and institutional investors contributed to the crisis by their overreliance on credit-rating firms, which in the aftermath of the crisis were accused of misrepresenting the financial strength of structured investment vehicles, giving investors impressions of high creditworthiness. Without such top ratings the market for such vehicles would have been smaller and not a bubble, possibly averting the crash.
Dodd-Frank was based on the belief that deregulation or lack of regulation caused the financial crisis. But Congress acted rashly in passing the legislation, not even waiting for the completion of the report on the causes of the crisis from its own Financial Crisis Inquiry Commission. The report, including the dissenting views it contains, would have helped Congress better focus the law. Instead, it took advantage of the times to take a scattershot approach.
A provision that banned banks from making markets in fixed-income securities has caused liquidity problems and might make the market vulnerable in a downturn. “New capital and leverage requirements ... can have the unfortunate effect of moving risk from more regulated and transparent sectors, such as banking and insurance, to the so-called shadow banking system, where these risks may be more difficult to discern and control,” Bruce I. Jacobs, principal, Jacobs Levy Equity Management Inc., remarked last year for Pensions & Investments' coverage of the fifth anniversary of Dodd-Frank.
The law targeted unrelated issues, creating a sweeping mandate for regulation. For example, the law requires companies to report the ratio of CEO pay to average pay, which reveals a misunderstanding of the role of compensation and is an intrusion on corporate matters better left to shareholders and boards. The requirement has nothing to do with market or financial stability and should be eliminated from Dodd Frank.
The law sought to end the doctrine of too big to fail — the bailing out of large financial institutions and creating a moral hazard in the markets — by seeking to identify systemically important financial institutions for special regulatory treatment. To that end it has led to targeting large money management firms, which were not the cause of the crisis but would face increased compliance costs that would be passed onto clients. MetLife Inc, a large insurance company with a money management unit, to its credit has fought the designation in court, winning the first round but currently facing an appeal. Designating money managers as SIFI deflects attention from real sources of financial instability that deserve scrutiny.
In establishing a collaborative rather than confrontational approach with the Trump administration, as well as reaching out to Congress, asset owners and other institutional investors would set a tone for policy harmony to strengthen markets, which would serve to strengthen fiduciary funds consistent with the new leadership's professed economic objectives to bolster all working participants.
