So what do I think of Dodd-Frank? I'm glad you asked. Before I get to some of the specifics, let me just say that in terms of broad policy, I am, unlike the vast majority of commentators, quite happy with the way the bill turned out. Barney Frank and Chris Dodd deserve a tremendous amount of credit for shepherding such a massive and impactful bill through Congress, and I think naming the bill "Dodd-Frank" is much deserved. The political and legislative realities involved in getting a major piece of legislation through Congress (and this is an uber-major piece of legislation) are so daunting nowadays that I had been expecting a far weaker bill from the beginning. That Dodd and Frank were able to get as much as they did is an extraordinary accomplishment.

No, Dodd-Frank doesn't do anything as sweeping as 1930s reforms, but you know what? We already have deposit insurance, there's already a Securities and Exchange Commission, and the massively overrated Glass-Steagall would have done exactly nothing to prevent the Bear Stearns and Lehman failures. Also, the financial crisis, while bad, wasn't even in the same league as the 1930s banking crises. So spare me the disappointed historical analogies.

Okay, now on to some specifics.

Overlooked: Interest on Demand Deposits

By far the most overlooked aspect of Dodd-Frank is Section 627, which repeals the long-standing prohibition on paying interest on demand deposits. This was one of the centerpieces of the Banking Act of 1933 — one of the policies Sen. Carter Glass personally demanded (the other being the pseudo-separation of commercial and investment banking). This could have far-reaching consequences, and yet was barely even discussed.

Revised Section 716

Next, because several people have asked, here's my take on the revised Section 716. The compromise language allows banks to keep making markets in swaps based on rates or reference assets that are authorized for investment in the Bank Powers Clause of the National Bank Act. Essentially, we're going back to the "look-through" approach to the Bank Powers Clause, but only for swaps. In practice, this means banks can keep their market-making desks in:

  • Interest-rate swaps;
  • FX swaps;
  • Cleared CDS referencing investment-grade names (e.g., CDS on GE, CDX.IG); and
  • Swaps on gold, silver, copper, platinum, and palladium.
Banks will have to spin-off (into their broker-dealer affiliates) their market-making desks in: equity swaps, any remaining commodity swaps, energy swaps, CDS on non-IG names, and uncleared CDS on IG names. In reality, the bank-permissible swaps in Section 716 represent well over 90% of the swaps market, so the provision will have very little substantive effect. But in that case, why have Section 716 at all? Why create yet another arbitrary bifurcation in the regulatory regime for derivatives — the same kind of arbitrary bifurcation which, by the way, gave rise to the OTC derivatives market in the first place (i.e., swaps vs. options/futures, and the infamous Swaps Exemption)?

The answer, as everyone knows by now, is that Blanche Lincoln wanted to get re-elected, and in the end couldn't bring herself to admit that she had inserted an extremely ill-advised provision into the Ag Committee bill at the last minute. It's not something to be proud of.

The drafting in the revised Section 716 is also horrible in several places. For example, § 716(i)(3) states:
NO LOSSES TO TAXPAYERS.—Taxpayers shall bear no losses from the exercise of any authority under this title.
First of all, what the hell does "taxpayers shall bear no losses" even mean? No outlays of government funds? Are "losses" being measured over a year? 5 years? 10 years? And who determines the value of the benefits taxpayers received (which is necessary to calculate net losses)? More importantly, this provision was clearly supposed to read, "the exercise of any authority under this paragraph," since the provision was a subparagraph of § 716(i), which addressed the treatment of a swaps entity's swaps and security-based swaps in FDIC receivership. But because of poor drafting, it applies to all of Title VII — is the CFTC going to be limited in its expenditures? Who knows. The frustrating thing is that § 716(i) is completely superfluous anyway (it just directs the FDIC to comply with applicable law), and was very obviously included for political reasons. This is the kind of thing that belongs in a press release, not actual legislation.

So in the end, the revised Section 716 is acceptable, despite being (a) bad policy, and (b) very poorly drafted.

Volcker Rule

I was highly critical of the Merkley-Levin amendment in the Senate, and unfortunately, the conference committee used Merkley-Levin as a template in their Volcker Rule negotiations. The final version of the Volcker Rule (sec. 619) is slightly better with regard to the prop trading ban, but it's still essentially a joke. The Street's lawyers will make short work of the prop trading language.

The conference committee fixed the language that would have allowed banks to simply move their prop desks to London, which is a positive. They also eliminated the exemption for trades done "in facilitation of customer relationships," which was an almost comically broad loophole. However, there's still no limitation on the definition of "market-making," which is still merely one of several categories of exemptions.

The conference committee also added more words to the "risk-mitigating hedging activities" exemption (§ 619(d)(1)(C)), but did nothing to actually narrow the exemption. Now the risk-mitigating hedging activity has to be "in connection with and related to individual or aggregated positions, contracts, or other holdings of the banking entity." This changes absolutely nothing about the bank's analysis under this exemption. Just as before, a bank simply has to identify a risk that it's facing — which will necessarily arise from "individual or aggregated positions, contracts, or other holdings of the banking entity" — and then justify the prop trade as a hedge against that risk. For the life of me, I can't think of a trade that would have been permitted under the previous "risk-mitigating hedging activities" exemption, but isn't permitted under the final language. And finally, the bill still includes the "catch-all" exemption for activities that "promote and protect the safety and soundness of the banking entity."

The final version inexplicably retains the illogical "conflict of interest" provision, which attempts to prohibit trades that "would involve or result in a material conflict of interest . . . between the banking entity and its clients, customers, or counterparties." This is simply incompatible with market-making, which the bill clearly and explicitly allows. It betrays a serious lack of understanding of the very concept of market-making. As a result, the Fed will now be forced to define "material conflict of interest" so narrowly that it will virtually never be applicable. Apparently this was Sen. Levin's pet provision, which, really, is embarrassing for Sen. Levin.

Finally, Dodd-Frank includes the so-called "hedge fund carve-out," which is really a "hedge fund and PE fund carve-out." It allows banks to invest 3% of their Tier 1 capital in hedge funds and PE funds. From a policy perspective, I think this is a bad idea. I had this argument with several people while the hedge fund carve-out was being debated. Proponents argue that it makes it much easier to raise money for a hedge fund if the bank that's promoting the hedge fund to investors is willing to invest some of its own money in the fund as well. I agree, that's true. Hedge funds are often "black box" investments — they're unwilling to reveal too much of their trading strategies to potential investors, out of fear that potential investors will simply steal their idea. To get investors comfortable investing in such "black box" hedge funds, the bank raising money for the fund will often invest some of its own money in the fund, as a show of good faith. In that sense, the "hedge fund carve-out" ensures that banks can continue to raise money effectively for hedge funds.

I don't dispute any of that. But is it really necessary for the financial system that we keep the hedge fund start-up machine well-oiled? I think not. So maybe 30 hedge funds instead of 40 launch per month. I certainly wouldn't lose any sleep, and I doubt Ben Bernanke or Tim Geithner would either. One thing we do not suffer from is a dearth of hedge funds (and I have lots of friends in hedge funds). Would it harm the hedge fund community? Marginally, yes. But that's not the same as saying it would be bad public policy.

But alas, the hedge fund community won the argument in the conference committee. To be honest, I consider capping the carve-out at 3% of Tier 1 capital to be something of a win — going into conference, the consensus on the Hill and on K Street was that the hedge fund carve-out would be capped at 10–15% of Tier 1 capital, and I'm legitimately surprised that it was scaled back so much.

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