The Triumph of Crony Capitalism: Part 2

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Assumptions Guiding the Act

The Act is guided by several broad concepts:

  1. Wall Street must be strictly regulated to prevent systemic risk and to promote financial stability.
  2. Large interconnected international financial companies are inherently risky.
  3. Excessive leverage leads to systemic risk.
  4. A lack of transactional transparency impeded necessary regulatory control.
  5. Investors lacked information to properly understand the nature of complex risky securities.
  6. Regulators are capable of carrying out the intent of the Act.

Specific blame for the financial collapse is assigned as follows:

Lenders, investment bankers, credit-rating firms, mortgage brokers and others had ample incentive to take risks, often with other people's money. That led to a bubble in credit: too much borrowing.

The explosion of trading in the shadowy worlds of derivatives and hedge funds hid risks, and perhaps even created new ones, without the transparency essential to well-functioning markets.

Big financial firms lacked sufficient capital cushions to withstand a shock, and assets they could sell quickly to raise needed cash. …

For the inevitable day when another big financial firm gets into trouble, the bill attempts to impose order and punishment—but gives authorities the power to use taxpayer money if they deem it necessary. …

Description of the Act

What is obvious from a review of the Act is that the powers granted are very broad, almost unlimited, ill-defined, and yet to be written. The following descriptions of the Act are intended to give you an idea as to the vast scope of the Act and the powers granted. I have picked out some of the more important powers, but the Act is much more invasive and controlling than what I am describing here. I have gone into some detail because I believe that most people don't understand how pervasive the Act is. Please bear with me here; it will be eye-opening.

Here is a major law firm’s (Gibson Dunn) overview of the Act:

[The Act] … seeks to increase financial marketplace transparency and stability by establishing a Financial Stability Oversight Council (the “Council”) focused on identifying and monitoring systemic risks posed by financial firms and by financial activities and practices. It establishes a new regulatory and supervisory framework for “large, interconnected” banking organizations and certain nonbank financial companies. By a two-thirds vote, the Council can determine which U.S. and foreign nonbank financial companies that are predominantly engaged in financial activities (together “NBFCs”) are to be subject to enhanced supervision (“Supervised NBFCs”) by the [Fed], based on the perceived risk a company poses to financial stability in the United States. Empowering the Fed to implement this regime substantially enhances its powers and responsibilities.

As you will see, the Act, while it comprises 2,300 pages, speaks mostly of legislative goals, with specific requirements that require fleshing out by rules and regulations that will follow. For the most part, the actual law will be developed by the mandarins.

The Concept of Financial Risk

The entire Act is built around the concept of protecting the “financial stability” of the economy. The term “financial stability” is mentioned about 80 times in the Act but there is no definition of what it is. The Act assumes that the Council will know it when it sees it.

Instead of defining the term, the Act assigns the new Financial Stability Oversight Council the duty of regulating companies whose activities threaten “financial stability.” The Council is obligated to conduct studies and make findings on which to base new rules and regulations which establish “prudential standards” for regulated companies. It is assumed that out of that process “financial stability” will be defined, but it seems no one really knows what “financial stability” is or what consists of a threat to it. Which is a problem is when you give vast powers to a new agency: it makes their powers almost unlimited.

The likelihood of finding this Act unconstitutional because of vagueness is low. Consider the fact that a Council takeover of a company because it is a “threat to financial stability” will probably only be challenged in the courts during a financial crisis. This puts pressure on judges who have little knowledge of economics. They would be afraid to assume responsibility for the economy. Since the experts testifying in court will most likely be mainstream economists and financiers who believe in current economic thinking that such powers are necessary to save the economy, it is unlikely that courts will believe the testimony of “outliers” such as Austrian theory economists.

The Act thus creates a board of economics czars who will have almost unlimited powers to regulate the financial sector of the economy.

Financial Stability Oversight Council

The Act creates a council of regulators, the Financial Stability Oversight Council, to monitor and regulate companies it believes have the ability to jeopardize financial stability. It is to be chaired by the Secretary of the Treasury. The Fed ends up as the primary regulator of financial firms and oversees the Council.

The idea is to prevent big “interconnected” banks and other large financial institutions such as hedge funds, investment banks, and insurance companies, from blowing up again. The extension of federal power to regulate nonbank financial institutions is a major expansion of federal authority.

The Council has the power to seize and break up financial firms whose collapse would put the economy in danger (“threaten the financial stability of the economy”). The Fed has the responsibility to decide whether the Council should vote on breaking up big companies. A position of a second Fed vice-chair is established to supervise financial firms; the White House appoints him or her (they have nominated Janet Yellen).

How the Rules Will Be Determined

The Council is given the following duties:

  1. Collect information from member agencies and other regulators, and research the issues.
  2. Adopt comprehensive regulations to control financial institutions.
  3. Monitor the financial services marketplace to identify potential threats to U.S. financial stability.
  4. Monitor domestic and international financial regulatory proposals and developments, including insurance and accounting issues.
  5. Advise Congress and make recommendations that will enhance the integrity, efficiency, competitiveness, and stability of the U.S. financial markets.
  6. Facilitate information sharing and coordination among the member agencies and other federal and state agencies regarding domestic financial services policy development, rulemaking, examinations, reporting requirements, and enforcement actions
  7. Recommend general supervisory priorities and principles.
  8. Identify gaps in regulation that could pose risks to U.S. financial stability.
  9. Require supervision by the Fed for nonbank financial companies that may pose risks to U.S. financial stability in the event of their material financial distress or failure, or because of their activities.
  10. Make recommendations to the Fed concerning the establishment of heightened prudential standards for risk-based capital, leverage, liquidity, contingent capital, resolution plans and credit exposure reports, concentration limits, enhanced public disclosures, and overall risk management for big interconnected banks and big financial institutions.
  11. Identify systemically important financial market utilities and payment, clearing, and settlement activities.
  12. Make recommendations to primary financial regulatory agencies to apply new or heightened standards and safeguards for financial activities or practices that could create or increase risks of significant liquidity, credit, or other problems spreading among big banks and other big financial institutions and U.S. financial markets.

Within 9 months they must adopt new regulations which must include:

  1. regulations implementing the permitted transactions provisions and any limitations on permitted transactions.
  2. regulations imposing additional capital requirements and quantitative limits (including diversification requirements) on permitted activities if the Regulators determine these limitations are appropriate to protect safety and soundness of banking entities engaged in permitted activities.
  3. regulations setting the ownership level in a fund that is "immaterial to the banking entity" which in any event cannot be more than 3% of the banking entity's own tier 1 capital [Volcker Rule]. The Volcker Rule will apply to any entity deemed to be systemically important nonbank financial companies
  4. regulations regarding internal controls and record keeping to insure compliance with the Rule.
  5. rules determining what "similar funds" are to be included in the definition of "hedge fund" and "private equity fund."
  6. rules defining the full extent of the definition of "trading account" for purposes of purposes of determining the scope of prohibitions on proprietary trading.
  7. rules defining additional securities that, if traded by a covered entity as a principal for its own trading account, constitute proprietary trading.
  8. rules defining additional accounts that count as "trading accounts" for purposes of determining the scope of the prohibition on proprietary trading.

Financial Institution Rules

Some of the key rules that apply to large ($50+ billion) interconnected financial companies include:

  1. The new “prudential standards” to be adopted by the Council may “differentiate” among companies, which means the Council can set “heightened standards” for some companies but not others, as they see fit.
  2. The new “prudential standards” may include risk-based capital requirements, leverage limits, liquidity requirements, resolution plan and credit exposure report requirements, concentration limits, a contingent capital requirement, enhanced public disclosures, short-term debt limits, and overall risk management requirements.
  3. The Council can limit a company’s leverage (i.e., debt to equity ratio) to 15 to 1, or less, if the company is found to pose a “grave threat to financial stability.”
  4. A new requirement requires regulated companies to “maintain a minimum amount of long-term hybrid debt that is convertible to equity in times of financial stress“ (”contingent capital”). In essence, the Council can require a company to convert this debt to equity in the event of a financial crisis. The Council has 2 years to study this and then tell us what this means.
  5. Regulated companies cannot have a credit exposure to a single unaffiliated firm that exceeds 25% of its capital and surplus.
  6. The “Volcker Rule” requires banks to limit proprietary trading to 3% of Tier 1 capital; they will have 7 years or longer to wind down such investments. The purpose of the rule is to restore “the Glass-Steagall barrier between commercial and investment banks” and to “update that barrier to reflect the modern financial world and permit a broad array of low-risk, client-oriented financial services.” In other words, banks, for the most part, will be more like utilities.
  7. A bank or a “systemically important nonbank financial company” is prohibited from acquiring or retaining any ownership interest in or sponsoring a hedge fund or private equity fund.
  8. Regulated companies cannot acquire any company with $10 billion or more in assets without giving the Fed prior notice.
  9. Banks must write “living wills” which is a roadmap for dissolution if seized by the government.
  10. Judicial review of a decision to subject a nonbank financial institution to the Council’s authority is limited to a finding that the decision was not “arbitrary and capricious.”
  11. To commence an “Orderly Liquidation Authority” (i.e., seizure of a financial institution determined to be in default or about to default), the Council must petition the D.C. District Court. The government only has to prove that (i) the company is in default or about to default, and (ii) the decision was not “arbitrary and capricious.” If the court fails to act within 24 hours of receiving the petition, the order goes into effect. The company affected may appeal the decision to the D.C. Court of Appeals, but the grounds of appeal are limited to the same findings as in the District Court. Once the petition is granted, the case proceeds similar to bankruptcy case.
  12. Do you recall President Obama’s promise that we taxpayers will never have to pay for bailouts again? That is not true, and they have found a way around unpopular bailouts. According to the Act, while the Fed cannot lend to specific companies it can lend as much as needed to “economic sectors”.
  13. Ron Paul’s efforts to gain oversight of the Fed were largely ignored, but the Act does prise open a small crack by allowing the GAO to audit certain emergency actions and the Fed must disclose the details of certain loan activity.

The Financial Stability Oversight Council has the power to do almost anything and there is very limited judicial review of their decisions. They justify these vast powers on their belief that they are necessary to protect the economy.

Disclosure: No positions