Chapter 2: The Dodd-Frank Act and the Financial Crisis: A Retrospective Assessment of the Act’s Systemic Risk Regulation Provisions
- International Monetary Fund. Legal Dept.
- Published Date:
- February 2013
The Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter “Dodd-Frank”) was signed into law by President Obama on July 21, 2010.1 Less than two and a half years earlier, Bear Stearns and Companies, one of Wall Street’s most storied and venerated investment banks, was merged with JP Morgan in a government-orchestrated transaction designed to avoid the firm’s impending failure. A few months later, Lehman Brothers would file for Chapter 11 bankruptcy and American International Group, Inc. would receive billions of dollars in loans from the federal government. The three companies, and Dodd-Frank’s passage, will forever be entwined in the recent financial crisis.
The near-failure of Bear Stearns, the failure of Lehman Brothers and the government rescue of AIG are often portrayed as impetuses for the Dodd-Frank provisions on systemic risk regulation. This article assesses, in a retrospective manner, the role that Dodd-Frank’s systemic risk regulation provisions could have played in monitoring these companies and mitigating the 2008 financial crisis.
Section I describes some of the relevant events occurring in 2008 that presented systemic risk implications for the U.S. economy and financial system. Section II summarizes the systemic risk provisions in Dodd-Frank. Section III presents evidence of the impact that Bear Stearns’ near-failure, Lehman Brothers’ failure, and AIG’s rescue had on Congress’s deliberations over Dodd-Frank, and section IV analyzes the potential impact that Dodd-Frank could have had, were it enacted at the time, in addressing the 2008 financial crisis.
The Financial Crisis in 2008
The precise start and end dates of the recent financial crisis cannot be identified with any degree of certainty. However, the year 2008, in particular fall 2008, often is viewed as the beginning of the financial crisis due to the sheer number of seismic financial events that occurred. The near-failure of Bear Stearns, the failure of Lehman Brothers, and the government rescue of AIG each illustrated that a single financial firm experiencing volatility could have significant consequences for the U.S. economy.
The Near-Failure of Bear Stearns
Bear Stearns’s stock price exceeded $150 per share in January 2007; in the month preceding its rescue, the share price was $93; and in early March 2008, Bear Stearns’ shares were trading at $30 and the company was faced with insolvency. Bear Stearns’ near-failure was not attributable to a single event or circumstance, but the sharp decline in its share price shows how quickly the market reacted to the company’s instability.
The Bear Stearns High-Grade Structured Credit Fund (“Structured Credit Fund”) and Bear Stearns High-Grade Structured Credit Enhanced Leverage Fund (“Enhanced Leverage Fund”) were hedge funds with exposure to the U.S. residential mortgage market. The Structured Credit Fund was started in 2004 and had posted positive returns for 41 months equal to approximately 1.5 percent per month by investing heavily in mortgage-backed securities.2 The Enhanced Leverage Fund, which was created less than a year before its ultimate liquidation, similarly invested in mortgage-backed securities. Both funds purchased substantial quantities of collateralized debt obligations (CDOs) with a combination of capital and leverage. When the value of these CDOs declined due to volatility in the U.S. housing market, the funds’ lenders demanded additional collateral to secure the loans used to acquire the CDOs. These demands forced the funds to sell off CDOs at significant losses. On July 17, 2007, Bear Stearns informed investors that the funds were close to worthless and would be liquidated.
Bear Stearns was highly leveraged3 and owned a significant volume of mortgage-backed securities. The beginning of 2008 marked a steady increase in market turmoil and fear that broader financial stability could result from the significant decline in the U.S. housing market.
On Monday, March 10, 2008, rumors circulated that Bear Stearns was out of cash.4 These rumors set in motion a “self-fulfilling feedback loop”5 that caused creditors to demand additional collateral from Bear Stearns. By Thursday, Bear Stearns’ liquidity reserves had decreased to $5.9 billion, of which $2.4 billion was owed to Citigroup.6
That Thursday, the Federal Reserve agreed to guarantee a $30 billion loan from JP Morgan to Bear Stearns through its emergency lending authority under section 13(3) of the Federal Reserve Act.7 The Federal Reserve’s guarantee ultimately enabled Bear Stearns to survive long enough to be acquired by JP Morgan at a significantly depressed price. Chairman of the Federal Reserve Ben Bernanke defended the federal government’s actions in terms of systemic risk:
Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets. The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company’s failure could also have cast doubt on the financial positions of some of Bear Stearns’ thousands of counterparties and perhaps of companies with similar businesses. Given the exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain. Moreover, the adverse impact of a default would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability.8
Bear Stearns was eventually sold to JP Morgan at a purchase price of $10 per share in JP Morgan common stock.
The Failure of Lehman Brothers
Lehman Brothers filed for Chapter 11 bankruptcy on September 15, 2008. Like Bear Stearns, Lehman Brothers had a considerable investment in subprime mortgages and mortgage-backed securities. Lehman Brothers also was highly leveraged-in the August preceding Lehman Brothers’ bankruptcy filing, the firm had approximately $600 billion in assets and $30 billion in equity.9 Accordingly, even a small decline in the firm’s assets would have a significant effect on the firm’s capital.10
In the summer of 2008, Lehman Brothers discussed options that would insulate the firm’s assets from the drag of the firm’s mortgage-related assets.11 In former CEO Richard Fuld’s testimony before the House Committee on Oversight and Government Reform, Mr. Fuld described a “bad bank” proposal that would have removed certain troubled assets from the firm’s balance sheet:
After the second quarter, Lehman Brothers developed a series of options to strengthen the firm, including working with regulators to develop a plan to separate the vast majority of our commercial real estate assets from our core business by spinning off those assets to our shareholders in an independent, publicly traded entity. We believed this plan would have improved our balance sheet while preserving shareholder value. The spinoff entity would have been able to manage the assets for economic value maximization over a longer time horizon.
Under the proposal, Lehman Brothers would have transferred approximately $30 billion in mortgage related assets to a separate, publicly traded company.12 The company would have been capitalized with capital injections from the firm as well as debt financing.13 Lehman Brothers did not have sufficient time to implement the proposal.
The firm also pursued a strategic investment with the Korea Development Bank (KDB). Reports indicated that the KDB was willing to inject up to $6 billion in capital into Lehman Brothers and would lead a consortium of Korean private investors.14 Korean regulators criticized the investment and negotiations with the KDB eventually fell through.15
Lehman Brothers’ share price dropped immediately after talks ceased with the KDB. On September 9, 2008, the firm’s shares lost 45 percent of their value, and the U.S. stock market declined 3.5 percent. The firm’s bankruptcy filing on September 15, 2008 was the largest bankruptcy filing in history, with the petition reporting $613 billion in debt.
Government Rescue of AIG
The U.S. economy had very little time to process the meaning of a Lehman Brothers bankruptcy before reports emerged that American International Group, Inc. (AIG) could be the next casualty in the financial crisis. AIG also had substantial exposure to the U.S. housing market in the form of mortgage backed securities and credit default swaps.
On September 16, 2008, the three primary credit rating agencies, Standard & Poor’s, Moody’s, and Fitch Ratings, downgraded AIG’s credit rating over concerns about increasing residential mortgage-related losses.16 The downgrades triggered provisions in AIG’s credit default swap contracts that potentially required AIG to post an additional $14.5 billion in collateral for the benefit of counterparties. The collateral calls implicated AIG’s liquidity resources. AIG’s share price decreased 21 percent for a total decrease in 2008 of approximately 94 percent.17
The U.S. federal government took action to prevent an AIG failure. On September 16, 2008, the Federal Reserve Bank of New York established an $85 billion credit facility for the firm collateralized by the firm’s assets in exchange for warrants amounting to 79.9 percent of AIG’s stock. The credit facility was increased to $122.8 billion in October 2008. On November 10, 2008, the Department of the Treasury purchased $40 billion in AIG preferred shares as part of the Emergency Economic Stabilization Act’s Troubled Asset Relief Program.18
Systemic Risk Regulation in Dodd-Frank
Article I of Dodd-Frank provides for systemic risk regulation. The Act establishes a new council of federal and state financial regulators-the Financial Stability Oversight Council-to monitor risks to U.S. financial stability, designate systemically important financial firms for enhanced prudential regulation by the Federal Reserve, and make recommendations to primary financial regulatory agencies to apply new or heightened prudential standards to existing financial institutions or existing financial activities.
Systemically important financial firms designated by the Council and bank holding companies with more than $50 billion in assets are subject to enhanced prudential regulation, including enhanced risk-based capital, liquidity, leverage, risk-management, and resolution plan requirements. This section summarizes the systemic risk provisions in Dodd-Frank.
Financial Stability Oversight Council
The Financial Stability Oversight Council (“FSOC” or “Council”) is chaired by the Secretary of the Treasury, and its voting members consist of the Chairman of the Federal Reserve Board of Governors, Comptroller of the Currency, Director of the newly created Bureau of Consumer Financial Protection, Chairman of the Securities and Exchange Commission, Chairperson of the Federal Deposit Insurance Corporation, Chairperson of the Commodity Futures Trading Commission, Director of the Federal Housing Finance Agency, Chairman of the National Credit Union Administration Board, and an independent director with insurance expertise appointed by the President.19 The Council’s non-voting members are the Director of the newly created Office of Financial Research,20 the Director of the newly created Federal Insurance Office, a state insurance commissioner, a state banking supervisor, and a state securities commissioner.21
The purposes of the Council are to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace; to promote market discipline by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the government will shield them from losses in the event of failure; and to respond to emerging threats to the stability of the United States financial system.22
Designation of Systemically Important Firms for Enhanced Prudential Regulation
The Council, by a vote of at least two-thirds of the voting members, including an affirmative vote by the Secretary of the Treasury, may designate a “U.S. nonbank financial company” or “foreign non-bank financial company” for supervision and prudential regulation by the Federal Reserve if the Council determines that material financial distress at the company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company, could pose a threat to the financial stability of the United States.23 A “U.S. nonbank financial company” is a company incorporated or organized under the laws of the United States or any state that is predominantly engaged in financial activities.24 A “foreign nonbank financial company” is a company incorporated or organized in a country other than the United States that is predominantly engaged in, including through a branch in the United States, financial activities.25
A company is “predominantly engaged in financial activities” if (1) the annual gross revenues of the company and all of its subsidiaries from activities that are financial in nature-as defined in section 4(k) of the Bank Holding Company Act-represent 85 percent or more of the company’s consolidated annual gross revenues, or (2) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature-as defined in section 4(k) of the Bank Holding Company Act-represent 85 percent or more of the company’s consolidated assets.26
In designating a nonbank financial company for supervision and prudential regulation by the Federal Reserve, the Council must consider the company’s leverage; the extent and nature of the company’s off-balance sheet exposures; and the extent and nature of the company’s transactions and relationships with other significant nonbank financial companies and significant bank holding companies.27 The Council also must consider the importance of the company as a source of credit for households, businesses, and state and local governments and as a source of liquidity for the U.S. financial system; the importance of the company as a source of credit for low-income, minority, or underserved communities; the extent to which the company’s assets are managed rather than owned by the company; the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company; the degree to which the company is already regulated by a primary financial regulatory agency (e.g., the Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Securities and Exchange Commission, the Commodity Futures Trading Commission), the amount and types of the company’s liabilities, including the company’s reliance on short-term funding; and any other risk-related factors that the Council deems appropriate.28
As part of its anti-evasion authority, the Council is authorized upon a vote of at least two-thirds of the Council, including an affirmative vote of the Secretary of the Treasury, to subject any company’s financial activities to supervision and prudential regulation by the Federal Reserve if material financial distress at the company or the company’s nature, scope, size, scale, concentration, interconnectedness, or mix of financial activities would pose a threat to U.S. financial stability and the company is organized or operates in such a manner as to evade designation by the Council.29 The Federal Reserve also is required to promulgate regulations on behalf of the Council setting forth criteria for exempting certain types or classes of U.S. nonbank financial companies or foreign nonbank financial companies from supervision by the Federal Reserve.30
After the Council votes to designate a nonbank financial company for supervision and prudential regulation by the Federal Reserve, the Council must provide written notice of the proposed determination to the company. The company may request a written or oral hearing to contest the Council’s determination within 30 days of receipt of the Council’s written notice. If a hearing is requested, the Council must provide one within 30 days of the request. The Council must make a final determination not later than 60 days after the hearing. The Council can waive or modify this timeframe if such waiver or modification is necessary or appropriate to prevent or mitigate threats posed by the nonbank financial company to the financial stability of the United States. A nonbank financial company may, within 30 days of the Council’s final determination, bring an action in the U.S. district court for the district in which the company’s home office is located or in the U.S. District Court for the District of Columbia for an order requiring that the Council’s final determination be rescinded on the grounds that the determination is arbitrary and capricious.31
Prudential Regulation for Designated Companies and Bank Holding Companies with over $50 Billion in Assets
The Federal Reserve is required to establish for nonbank financial companies designated for Federal Reserve supervision (“Designated Companies”) and bank holding companies with more than $50 billion in assets (“Interconnected Bank Holding Companies”) prudential standards with respect to risk-based capital, leverage limits, liquidity requirements, risk management requirements, resolution plans, credit exposure report requirements, and concentration limits that are more stringent than the standards applicable to financial companies and bank holding companies that do not present similar risks to U.S. financial stability.32 The Federal Reserve may also establish additional prudential standards with respect to contingent capital requirements, enhanced public disclosure requirements, and short term debt limits.33 The Federal Reserve may establish an asset threshold above $50 billion in defining what is an Interconnected Bank Holding Company, but only in regard to requirements relating to contingent capital, resolution plans, credit exposure reporting, concentration limits, enhanced public disclosure, and short-term debt limits.34 The Council is authorized to make recommendations to the Federal Reserve concerning these prudential standards as well as an asset threshold higher than $50 billion for bank holding companies.
Designated Companies may be required to submit reports under oath to the Federal Reserve concerning the company’s financial condition and compliance with the Act, and the Federal Reserve also can examine Designated Companies.35 The Federal Reserve is authorized to take enforcement action against a Designated Company in the same manner as if the Designated Company were a bank holding company. Designated Companies are treated as bank holding companies for purposes of Section 3 of the Bank Holding Company Act, which regulates bank acquisitions.36 Designated Companies, as well as Interconnected Bank Holding Companies, must provide written notice to the Federal Reserve in advance of acquiring a direct or indirect ownership interest in a company with $10 billion in assets or more that is engaged in activities that are financial in nature.37
If the Federal Reserve determines that a Designated Company or Interconnected Bank Holding Company poses a “grave threat” to U.S. financial stability, the Federal Reserve, upon a two-thirds vote of the Council, may limit the company’s ability to merge with, acquire, consolidate with, or become affiliated with another company; restrict the company’s ability to offer certain financial product or products; require the company to terminate one or more activities; impose conditions on the manner in which the company conducts one or more activities; or, if these actions are inadequate, require the company to sell assets or off-balance-sheet items to unaffiliated entities.38
Designated Companies and Interconnected Bank Holding Companies must submit a plan for the company’s rapid and orderly resolution in the event of material financial distress, as well as submit reports on the company’s credit exposure to other Designated Companies and Interconnected Bank Holding Companies as well as other Designated Companies’ and Interconnected Bank Holding Companies’ exposure to the company.39 The Council may make recommendations to the Federal Reserve concerning this requirement. The Federal Reserve is required to prescribe standards that prohibit Designated Companies and Interconnected Bank Holding Companies from having credit exposure to any unaffiliated company that exceeds 25 percent of the capital stock and surplus of the company.40 The Federal Reserve also may prescribe limitations on the amount of short-term debt, including off-balance sheet exposures, that may be held by a Designated Company or Interconnected Bank Holding Company.41 The Council is authorized to make recommendations to the Federal Reserve concerning these requirements.
The Federal Reserve must require Designated Companies that are publicly traded to establish a risk committee to be responsible for the oversight of the enterprise-wide risk management practices of the Designated Company and that has a minimum number of independent directors as prescribed by the Federal Reserve.42 Designated Companies and Interconnected Bank Holding Companies must submit to annual stress tests to be conducted by the Federal Reserve to evaluate whether the company has capital necessary to absorb losses that result from adverse economic conditions.43 In addition, all financial companies with more than $10 billion in assets and that are regulated by a primary Federal financial regulatory agency must conduct self-stress tests, to be prescribed and defined by regulations issued by such agencies.44
The Federal Reserve must require Designated Companies and Interconnected Bank Holding Companies to maintain a debt-to-equity ratio of no more than 15-to-1, upon a determination that the company poses a grave threat to U.S. financial stability and that such requirement is necessary to mitigate risks presented by such company to U.S. financial stability.45 The Federal Reserve, in consultation with the Council and FDIC, is to prescribe regulations establishing requirements for early remediation of financial distress at a Designated Company or Interconnected Bank Holding Company.46
The Federal Reserve may require Designated Companies that conduct both financial and non-financial activities to establish and conduct all financial activities in or through an intermediate holding company established by Federal Reserve regulation.47 Internal financial activities, such as internal treasury, investment, and employee benefit functions, may continue to be performed in the Designated Company itself.48 The Council may provide for more stringent regulation of a financial activity by issuing recommendations to the primary financial regulatory agencies, including state insurance regulators, to apply new or heightened standards and safeguards for a particular financial activity or practice conducted by a financial institution.49
The 2008 Crisis’s Impact on Dodd-Frank
The need for systemic risk regulation in the U.S. financial regulatory framework was articulated in the Department of the Treasury’s Blueprint for a Modernized Regulatory Structure in March 2008. The Blueprint called for a “market stability regulator” to “focus on the stability of the overall financial sector in an effort to limit spillover effects to the overall economy.”50 However, the Blueprint was issued before the full magnitude and scope of the financial crisis became fully known later in 2008.
In October 2008, Congress enacted the Emergency Economic Stabilization Act,51 which authorized Treasury to purchase troubled assets from financial institutions and provided the statutory basis that Treasury would use to purchase preferred shares in banks, thrifts, and bank and thrift holding companies through the Troubled Asset Relief Program’s Capital Purchase Program. A little-noticed provision in the Emergency Economic Stabilization Act eventually would provide much of the impetus for Congress’s consideration of financial regulatory reform. Section 105(c) of the Act required Treasury to “review the current state of the financial markets and the regulatory system” and to submit a report “analyzing the current state of the regulatory system and its effectiveness at overseeing the participants in the financial markets….”
In June 2009, Treasury released its report, Financial Regulatory Reform: A New Foundation, providing an overview of financial regulatory reform proposals including systemic risk regulation and resolution of systemically important firms. Bear Stearns, Lehman Brothers, and AIG are referenced several times in the New Foundation report, including in connection with the need to subject investment banks to more stringent, consolidated supervision and regulation by the Federal Reserve and for a resolution regime for large, systemically important financial firms.52
Throughout the summer of 2009, Treasury released draft legislation that would carry out the reforms outlined in the New Foundation report. Treasury’s draft systemic risk regulation was released on July 22, 2009. The House Financial Services Committee would be the first legislative panel to take up financial regulatory reform.
The House Financial Services Committee held dozens of hearings related to Treasury’s financial regulatory reform proposals. Understandably, the 2008 financial crisis was frequently raised as a cautionary tale of what could happen again without financial regulatory reform. The failure to regulate large, systemically important entities was cited as one of the main arguments for systemic risk regulation.
When the Committee started drilling down into the specific legislative provisions, the specific conditions and circumstances that precipitated the three companies’ financial troubles and the 2008 financial crisis generally came into focus. Secretary Geithner, in testimony before the Committee, noted systemically important institutions’ excess leverage, stating that “[t]he biggest part of the failure of our system was to allow very large institutions to take on leverage without constraint. … And that is why a centerpiece of any reform effort has to be the establishment of more conservative constraints on leverage applied to institutions whose future could be critical to the economy as a whole.”53
Representative Kenny Marchant (R-TX) focused his questions during a September hearing on short-term overnight funding as a particular type of leverage that could pose risk to institutions. Rep. Marchant posited that over-reliance on short-term overnight funding was another symptom of the 2008 financial crisis. Secretary Geithner readily agreed: “I think you are exactly right, that it is not just the scale of leverage but the extent to which we are reliant on very short-term funding that can flee in a heartbeat. And that is what brought the system crashing down.”54
The House Financial Services Committee approved the systemic risk regulation provisions of legislation in November 2009, and the House passed the consolidated financial reform legislation in December 2009. The Senate Banking Committee took up financial regulatory reform in 2010.
The Senate Banking Committee’s consideration of systemic risk regulation also used the three companies as illustrations and used the 2008 financial crisis as a focal point. Chairman of the Senate Banking Committee Christopher Dodd (D-CT) referenced Bear Stearn’s near-failure to criticize the delay in adopting financial regulatory reform: “But nearly two years after the collapse of Bear Stearns, we still have not updated the laws governing our financial sector, leaving our fragile economy with the same vulnerabilities that led to the economic crisis in the first place.”55
When Congress deliberated financial regulatory reform legislation in 2009 and 2010, it confronted a series of failures and near-failures of large systemically financial institutions. These episodes formed a constellation of financial regulatory gaps that provided a roadmap for Congress in drafting the systemic risk regulation provisions in Dodd-Frank. The 2008 financial crisis highlighted the need for careful consideration of issues such as leverage and short-term funding and played a considerable role in Dodd-Frank’s passage.
Dodd-Frank’s Potential Impact on the 2008 Financial Crisis
It is difficult, if not perilous, to pose counterfactuals for economic events such as the financial crisis in 2008. The crisis cannot be attributed to a single event or series of events. Indeed, the events at issue were not limited solely to the activities of systematically important nonbank financial institutions. But even as to that particular slice of the crisis, which is the subject of this article, the complex interplay of economic, political, and social forces affecting Bear Stearns, Lehman Brothers, and AIG in 2007 and leading up to September of 2008 is not readily unpacked into various inflection points that can be analyzed, in isolation, in the context of recently-enacted legislation. Accordingly, the aim of this section is not to render a verdict on whether Dodd-Frank, had it been enacted at all relevant points prior to the 2008 financial crisis, would have prevented the demise of Bear Stearns, Lehman Brothers, or AIG. Instead, this section more manageably seeks answers to a few key questions relating to Dodd-Frank and the 2008 financial crisis in general:
Would the Financial Stability Oversight Council have designated Bear Stearns, Lehman Brothers, or AIG as systemically important financial firms?
How would the restrictions on leverage in Dodd-Frank have affected the 2008 financial crisis?
What other provisions in Title I of Dodd-Frank may have been relevant to the 2008 financial crisis?
Would the Financial Stability Oversight Council Have Designated Bear Stearns, Lehman Brothers, or AIG as Systemically Important Financial Firms?
It is likely that Bear Stearns, Lehman Brothers, and AIG would have been designated by the FSOC for enhanced prudential supervision by the Federal Reserve based on the considerations set forth in section 113(a)(2) of Dodd-Frank.56 All three firms were large institutions by asset size, interconnected with other significant financial institutions, and an important source of credit for households given their roles in the mortgage securitization markets.
With regard to the specific factors in section 113(a) of the Act,57 as of November 30, 2007, Bear Stearns had over $395 billion in assets,58 Lehman Brothers had over $691 billion in assets,59 and as of December 31, 2007, AIG had over $1.06 trillion in assets.60 Bear Stearns was highly leveraged by all accounts in 2007 and 2008, with a debt-to-equity ratio of approximately 33-to-1 at one point,61 and Lehman Brothers had a debt-to-equity ratio of 30-to-1.62 These companies also had a considerable amount of off-balance sheet exposures.63 They engaged in a significant number of major transactions with other significant nonbank financial companies.64 The companies also were an important source of credit for households, businesses, and state and local governments. The firms played a major role in purchasing and securitizing mortgage backed securities and underwriting credit default swaps on such securities. This role helped facilitate a steady source of liquidity for mortgage lenders to make mortgage loans.
Although Bear Stearns and Lehman Brothers also were regulated by the Securities and Exchange Commission, neither one was subject to consolidated bank-like supervision. Similarly, AIG was subject to various forms of regulation from insurance supervisors and by the Office of Thrift Supervision, but the oversight by this thrift regulator was generally limited to AIG’s federal savings bank, AIG FSB, and the impact that AIG’s activities as a whole could have on AIG, FSB. The firms also had a substantial amount of liabilities, a significant amount of which was short-term, overnight funding.65
The FSOC is authorized to consider any other “risk-related factors” that it deems appropriate in determining whether to subject a nonbank financial company to enhanced prudential regulation by the Federal Reserve. This confers discretion upon the FSOC to assess the company’s potential impact on U.S. financial stability in light of factors not articulated in Dodd-Frank. Therefore, in the event that the FSOC’s weighing of the statutorily-mandated considerations did not support subjecting the companies to enhanced prudential regulation by the Federal Reserve, the FSOC would have been free to consider other factors and to make a designation on the basis of such factors.
As shown in the previous section, Congress was influenced by the 2008 financial crisis in setting forth the considerations in section 113(a)(2) to be weighed by the Council. The financial crisis in 2008 supplied Congress with many of the symptoms that it sought to monitor in the future, and Dodd-Frank empowers the FSOC to subject nonbank financial firms to enhanced prudential regulation on the basis of such symptoms. It follows that hypothetical application of those same considerations to the three companies that personified the 2008 financial crisis would in all likelihood result in the firms being subjected to Federal Reserve regulation by the FSOC.
How Would the Restrictions on Leverage in Dodd-Frank Have Affected the Financial Crisis in 2008?
Systemically important financial companies in 2008 such as Bear Stearns, Lehman Brothers, and AIG would have been subject to leverage limits established by the Federal Reserve pursuant to section 165(b)(1)(A). The Federal Reserve’s authority to prescribe a leverage limit for nonbank financial companies allows it to prescribe limits on an individual company basis. Therefore, the Federal Reserve presumably would have prescribed a leverage limit based on the firms’ financial condition, of which the Federal Reserve would have had a complete picture given the Federal Reserve’s periodic examinations. These leverage limits probably would have made it more difficult for systemically important firms to grow portfolios of mortgage backed securities and similarly would have likely improved the firms’ liquidity profiles by mitigating the destabilizing effect of creditors’ margin calls (at the cost of lost earnings from less leverage).
Moreover, the firms would have been subject to a mandatory 15-to-1 debt-to-equity ratio in the event that the FSOC determined that the firms posed a grave threat to U.S. financial stability and that such a limitation was necessary to mitigate the risk posed.66 Finally, the Federal Reserve also would have been authorized to establish by regulation a limit on short-term debt, including off-balance sheet exposures. If the Federal Reserve decided that such a limit was necessary to mitigate the risk that over-accumulation of short-term debt posed, the firms would have been subject to such limitations. The impact of this short-term debt limit may have forced systemically important financial firms to turn to other sources of credit with longer maturities. Replacing short-term debt with longer-term debt presumably would have better aligned the maturities of the firms’ debts with the maturities of their assets, which consisted heavily of mortgage-backed securities tied to 30-year home mortgages.
The financial industry’s leverage problems resulted not simply from the amount and type of leverage, but also from the market’s lack of information on large systemically important institution’s leverage profiles. Because the full extent of the industry’s leverage problems was unknown, rumors circulating in the market leading up to September 2008 gained traction and compounded liquidity problems. Enhanced prudential regulation of systemically important firms likely would have mitigated the extent of such leverage problems. Leverage limitations similarly would have improved the industry’s liquidity profile from a volatility perspective, and the Federal Reserve’s examination of systemically important firms could have given regulators a better sense of the firms’ risk exposure to disruption in short-term funding.
What Other Provisions in Title I of Dodd-Frank May Have Been Relevant to the 2008 Financial Crisis?
Several provisions in Dodd-Frank would have increased oversight and monitoring of systemically important financial firms. In particular, nonbank financial companies subject to Federal Reserve prudential regulation would have been subject to mandatory stress tests designed to evaluate whether the firms had the capital, on a consolidated basis, to absorb losses as a result of adverse economic conditions. The Federal Reserve’s stress tests of the 15 largest bank holding companies in May 2009 used indicative loss rates for mortgage loans and mortgage-backed securities that were much higher than the loss rates used by banks before the collapse of the U.S. housing market. A similar stress test for systemically important firms could have shown the need for additional capital to weather more adverse economic scenarios, and also could have given the Federal Reserve a better sense of the firms’ exposure to the U.S. housing market.
Dodd-Frank also authorizes the Federal Reserve to require non-bank financial companies to make periodic public disclosures to support the market’s evaluation of the company’s risk profile, capital adequacy, and risk management capabilities. If the Federal Reserve promulgated regulations under this provision, the enhanced disclosures that systemically important firms would have been required to make may have made sufficient information available to the market to mitigate rumor-inspired margin calls.
Finally, the Federal Reserve’s authority under section 121 of Dodd-Frank to take extraordinary actions with respect to a nonbank financial company when it determines that such company poses a grave threat to U.S. financial stability may have provided the Federal Reserve with sufficient tools to prevent systemically important firms from being so vulnerable to market rumors.
The economic crisis in 2008 can be attributed, in part, to over-leveraging, over-reliance on short-term funding, and under-reporting of systemically important firms’ financial condition to the market. Dodd-Frank addresses the systemic risk posed by nonbank financial companies in two distinct manners: first, by imposing Federal Reserve-prescribed prudential standards, including limitations on leverage and short-term funding, and second, by providing for enhanced disclosure of information to the market and by subjecting nonbank financial firms to examination and supervision. These constraints in all likelihood could have prevented firms from rapidly increasing leverage and could have at least given the Federal Reserve more warning of systemically important firms’ condition.
Pub. L. No. 111-203 (July 21, 2010) (hereinafter “Dodd-Frank”).
See Julie Creswell & Vikas Bajaj, “Bear Stearns in $3.2 Billion Bailout of Fund,” N.Y. Times, June 23, 2007, at A1.
Id. at 474 (citing Bear Stearns’ Form 10-K).
See Jeff Kearns & Yalman Onaran, Bear Stearns Shares Fall on Liquidity Speculation, Bloomberg.com (Mar. 10, 2008) (“‘There’s an insolvency rumor and concerns on liquidity, that they just have no cash,’ said Michael Main-wald, head of equity trading at Lek Securities Corp. in New York.”).
See Steven M. Davidoff and David Zaring “Regulation by Deal: The Government’s Response to the Financial Crisis,” 61 Admin. L. Rev at 463, 476 (2009).
Kate Kelly, “Fear, Rumors Touched Off Fatal Run on Bear Stearns,” Wall St. J., May 28, 2008, at A1.
Section 13(3) of the Federal Reserve Act authorizes the FRB to make loans to any person, partnership, or corporation in “in unusual and exigent circumstances.”
Statement by Ben Bernanke, Chairman of the Federal Reserve Board, Hearing Before the Senate Committee on Banking, Housing, and Urban Affairs (Apr. 3, 2008).
See CNBC.com, Lehman Brothers Files For Bankruptcy, Scrambles to Sell Key Business (Sept. 16, 2008) available at http://www.cnbc.com/id/26708143/Lehman_Brothers_Files_For_Bankruptcy_Scrambles_to_Sell_Key_Business.
See Statement of Richard Fuld, Chief Executive Officer of Lehman Brothers, Hearing Before the House Committee on Oversight and Government Reform (Oct. 6, 2008).
See Ben White & Jenny Anderson, “Lehman Weighs Split to Shed Troubling Loans,” N.Y. Times, Sept. 4, 2008.
See Kelly Olsen, “Korea Development Bank May Buy Lehman Bros.,” USA Today, Sept. 2, 2008.
See Bomi Lim & Seonjin Cha, Korea Development Bank Ends Talks for Stake in Lehman, Bloomberg.com, Sept. 10, 2008.
See James Quinn, “AIG’s Credit Ratings Slashed as Wall Street Drama Intensifies,” The Telegraph, Sept. 16, 2008.
See Matthew Karnitschnig et al., “U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit,” Wall St. J., Sept. 17, 2008.
See Press Release, Department of the Treasury, “Treasury to Invest in AIG Restructuring Under the Emergency Economic Stabilization Act” (Nov. 10, 2008).
Dodd-Frank § 111(b)(1).
The Act establishes the Office of Financial Research within the Department of the Treasury to serve as the Council’s economic and statistical research arm and to collect information on the U.S. economy and from systemically important financial firms. See Dodd-Frank, Subtitle B.
Dodd-Frank § 111(b)(2).
See Dodd-Frank § 112(a).
Dodd-Frank § 113(a)(1).
Dodd-Frank § 102(a)(4)(B). See also 76 Fed. Reg. 7731 (Feb. 11, 2011) (Notice of Proposed Rulemaking regarding definition of “predominantly engaged in financial activities”).
Dodd-Frank § 102(a)(4)(A).
Dodd-Frank § 102(a)(6).
Dodd-Frank § 113(a)(2).
Dodd-Frank § 113(c).
Dodd-Frank § 170.
See Dodd-Frank § 113(e).
Dodd-Frank § 165(a). See, e.g., 77 Fed. Reg. 594 (January 5, 2012) (Notice of Proposed Rulemaking regarding enhanced prudential standards) and 76 Fed. Reg. 35351 (June 17, 2011) (Notice of Proposed Rulemaking regarding capital plan requirement).
Dodd-Frank § 165(b)(1)(B).
Dodd-Frank § 165(a)(2)(B).
Dodd-Frank § 161(a).
Dodd-Frank § 162(a).
Dodd-Frank § 163(a).
See Dodd-Frank § 121.
Dodd-Frank § 165(d)(1). See 76 Fed. Reg. 22648 (Apr. 22, 2011) (Notice of Proposed Rulemaking regarding resolution plans and credit exposure reports).
Dodd-Frank § 165(e)(2).
Dodd-Frank § 165(g).
Dodd-Frank § 165(h).
Dodd-Frank § 165(i)(1).
Dodd-Frank § 165(i)(2); see 77 Fed. Reg. 594 (van. 5, 2012) (Notice of Proposed Rulemaking regarding stress test requirement).
Dodd-Frank § 165(j)(1).
Dodd-Frank § 166.
Dodd-Frank § 167(b)(1)(A).
Dodd-Frank § 167(b)(2).
See Dodd-Frank § 120.
Department of the Treasury, Blueprint for a Modernized Regulatory Structure 146 (Mar. 2008).
Pub. L. No. 110-343 (Oct. 3, 2008).
See, e.g., Department of the Treasury, Financial Regulatory Reform: A New Foundation 34 (June 2009).
See Statement of Timothy Geithner, Secretary of the Treasury, Hearing Before the House Financial Services Committee p. 16 (Sept. 23, 2009).
Id at 41.
See Prepared Remarks of Senator Christopher Dodd, Hearing Before the Senate Banking Committee (Feb. 4, 2010).
In October 2008, the two largest investment banks—Goldman Sachs and Morgan Stanley—converted from the traditional investment bank structure to the commercial bank holding company structure. Bank holding companies with $50 billion in assets automatically are subject to enhanced prudential supervision by the Federal Reserve under Dodd-Frank. Accordingly, it is unlikely that the FSOC will have cause to assess in the near-term whether a large investment bank like Bear Stearns should be designated for enhanced prudential supervision.
See supra pp. 8-9.
See Bear Stearns & Co. Form 10-K (for the period ending November 30, 2007).
See Lehman Brothers, Report of Q1 2008 Results.
See American International Group, Form 10-K (for the period ending December 31, 2007).
See Davidoff & Zaring, 61 Admin. L. Rev. at 474.
See Vikas Bajaj et al., “Radical Shift For Goldman and Morgan,” N.Y. Times, Sept. 21, 2008.
See, e.g., Bear Stearns & Co. Form 10-K (for the period ending November 30, 2007) (stating that Bear Stearns’ available liquidity pool accounted for “financing haircuts for certain off-balance sheet financing transactions.”).
See Reuters, Merrill Lynch Seizes Bear Stearns Fund Assets (June 16, 2007); Andrea Felsted & Kate Burgess, “AIG Forms Keystone of Financial System,” Financial Times, Sept. 15, 2008 (“I don’t know of a major bank that doesn’t have some significant exposure to AIG. That would be a much bigger problem than most that we’ve looked at.”).
See supra pp. 5-6.
See Dodd-Frank § 165(j).