Two Nobel Prize winning economists believe Dodd-Frank may have missed the mark when it comes to financial reform.
It has been at least five years since the first signs of the financial crisis began to appear. Despite the passage of time, there is no consensus about what caused the debacle, which culminated in the collapse of Lehman Brothers, a freeze in the credit markets, and a worldwide recession. The prevailing view in the media and government circles and much of the public is that it was caused by “a reckless private sector, driven by greed and insufficient regulation,” notes Leo Melamed, CME Group chairman emeritus. Others, he says, place the blame among those who supported and developed the government’s housing policies. Looking to supplement those views of the crisis with fresh insight, Melamed spoke in late 2011 with two Nobel prize winning economists – Robert Merton and Myron Scholes.
Merton and Scholes shared a Nobel prize in 1997 for their work on valuing derivatives, and Scholes is the co-originator of the Black-Scholes method of valuing options. The conversation took place following Scholes and Merton receiving CME Group’s 2011 Fred Arditti Innovation Award at the Global Financial Leadership Conference. Scholes and Merton argue that various strains of conventional wisdom have failed to fully explain the causes of the crisis – and that efforts to re-regulate the markets have been off target. “We should really think about what are the sources of systemic risk in the markets. And not look at the institutions,” Merton advises. “I think that the Dodd Frank bill was based on retribution and anger and not really based on science.”
Systemic risk has been part of every financial system, but several elements have made it more prevalent in recent years, according to Scholes. He points to a combination of globalization, financial and technological innovation and unusually low interest ratesthat have induced more risk taking among investors. At the same time, a “shadow” banking system beyond the review of regulators took root among hedge funds, money market funds, structured finance vehicles and other non-traditional institutions. All of this occurred in the context of rapid population growth, which boosted demand for financial products and also added to a supply of capital.
Who’s minding the store?
Scholes says it is obviously important to understand institutions, but that such understanding is a very “tactical” piece of knowledge. “What you really want to think about is what’s driving it,” he says. Those drivers included government coordination that forced “all the different players to line up together in the same direction.” The government also created a “feedback loop” of guarantees, in which guarantors are guaranteeing some entity that is in turn guaranteeing the guarantor. As an example, he points out that the FDIC issues bonds. “Who holds them,” he asks. “FDIC insured banks.” The accounting system was another major element of systemic risk, according to Scholes. “I think it’s a travesty,” he said. “If you know the accounting stuff is meaningless…and you are in a crisis, it just accentuates it.”
The Dodd-Frank Wall Street Reform and Consumer Protection Act largely failed to address those deeper problems, driven as more by politics than economics, according to Merton and Scholes. In 1934, the U.S. Congress responded to the financial market crash and the Great Depression with the Glass-Steagall Act. It was only about 25 pages long, and it included all of the regulations that it mandated, according to Merton. In contrast, Dodd-Frank is more than 2,000 pages along, filled with exemptions that muddy its meaning, and includes few of the regulations that it has mandated, he said.
And despite its breadth, it does not address the problems with Fannie Mae and Freddie Mac, weaknesses in the accounting system, a fractured regulatory regime of nearly a dozen agencies, or the need for capital standards, which are left to Basel negotiators, according to Merton. The best part of the legislation, in Scholes’ view, is the creation of an Office of Financial Research, to combine and coordinate data on the markets, including positions, exposures and cross linkages. While he would have preferred an independent agency, instead of one located in the U.S. Department of Treasury, Scholes says the research group could challenge regulators the way that the National Transportation Safety Board prods the Federal Aviation Administration. One of the biggest mandates of the Dodd-Frank Act is the Volcker Rule, which forces banks out of the business of trading for their own account. “I’m not philosophically opposed to the idea that institutions may not be able to engage in certain activities if they do engage in others…I am willing to look at it,” Merton states. “But by and large I haven’t been very impressed with what I’ve seen is the way it’s going to be executed,” he says.
The rule may just force proprietary trading into other parts of the financial system. Merton says other problems – such as the need to fix the accounting regime or the forces driving correlation of assets – are more important than the problems with proprietary trading. Scholes says there are behavioral elements to the financial crisis and re-regulation, too. People tend to under estimate the risk of things that are familiar to them. For example, Scholes worries about the pension system, noting that the typical Employee Retirement Income Security Act (ERISA) corporate pension plan holds 70 percent of its assets in equities.
That is the equivalent of the old General Motors, which had a market cap of $100 billion, entering into a $70 billion total return swap, according to Scholes. “And yet, we don’t think of it that way. Why? Because it’s familiar. If it were a derivative, you’d be running people out the door,” he declares. Given a future in which system risks may remain high, investors must learn to live with uncertainty, Merton advises. “To make money in your business you have to understand uncertainty. How do you handle the various paths and trajectories that could occur? How much flexibility should you build into your operating and financing plans? That is the fundamental question in all businesses.”