Does Dodd-Frank Have Real Teeth?

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- When Dodd-Frank was enacted on July 21, 2010, nobody was happy. I did not believe the Act dealt with the causes of the banking collapse, and I was not alone. On the other hand, many in banking believed the law was far too restrictive. There is general agreement that the law is too wordy (368,925) and complex. Since it was enacted, almost two years ago, it is worth taking a close look at both the language of the bill and what has changed in the banking industry since its enactment.

Key Provision: The Volcker Rule

Former Treasury Secretary Paul Volker does not believe banks should be allowed to trade for their own account -- too risky. It is interesting to look at how his influence ebbed and flowed during the bill's development.

Just after the bank collapse, everyone was looking to Volcker on what should be done. Obama seemed quite taken with him. But Larry Summers, Tim Geithner and their buddies in the financial industry did not want the Volcker Rule in the bank reform bill, so all of a sudden, he was no longer a White House regular. But in Congress, his influence remained strong -- Barney Frank, Carl Levin, et al.

So where is Volcker in the bill? Title VI, Sec. 619, (a)(1) reads:

"Unless otherwise provided in this section, a banking entity shall not -- (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund. ... In no case may the aggregate of all of the interests of the banking entity in all such funds exceed 3% of the Tier 1 capital of the banking entity."

That sounds pretty good. So let's look at this from some other perspectives.

Developments in the Banking Industry

In 1951, U.S. financial profits were 8% of total corporate profits. By 2003, the financial share had increased to 33%. One Third! In 2010, after the bank collapse, they were still 26% of total U.S. corporate profits.

What impact has the legislation had, or is it expected to have? Gabriel Sherman just interviewed a number of bankers on this question. In a New York Magazine article, he reported that the bill has real bite:

  • A quote from JPMorgan Chase CEO Jamie Dimon: "Certain products are gone forever. ... Fancy derivatives are mostly gone. Prop trading is gone. There's less leverage everywhere. Mortgages are back to old-fashioned conservative mortgages. ..."

  • Sherman on Goldman Sachs: "Months before the Volcker Rule is set to kick in, star traders began to leave in droves. In March 2010, Pierre-Henri Flamand, the London-based global head of Goldman's Principal Strategies group, quit. ... In September, Goldman revealed it was shuttering its entire desk. ... Goldman was the first of the major banks to announce it was shuttering its internal hedge funds."

  • Sherman on Morgan Stanley: "Morgan Stanley announced ... it was getting out of prop trading entirely. The bank decided to spin off its secretive Process Driven Trading unit, a 70-person desk run by Peter Muller. ... After disbanding Muller's group, Morgan Stanley announced it had finished spinning off FrontPoint Partners, a multibillion-dollar hedge fund. ..."

  • On Citigroup: "Citigroup announced that it, too, was closing its prop-trading desk."
Sherman also reported that the Fed plans to double the reserves banks will have to hold over the next few years.

Federal Deposit Insurance Corporation Bank Data

The Sherman article certainly gives the impression that Dodd-Frank has teeth and that a real deleveraging revolution has started in the banking industry. But before accepting this as fact, let's look at September 2011 FDIC data on banks. Table 1 provides information on the four largest U.S. banks. The table includes values for the end of September 2011 and the percent change since June 2007 (before the banking collapse). It appears the big banks are getting bigger:

  • Employment has grown significantly for all but Citibank.

  • Total assets are up as well, with each bank having more than $1 trillion (note there are only 15 countries with GDPs in excess of $1 trillion).

  • The banks are getting out of trading? Why then, for all but Bank of America, are trading account assets up? Why then, for all but JP Morgan Chase, are derivatives up significantly?

The table also includes data on Tier 1 assets as a percent of deposits. These have understandably strengthened since 2007. And certainly, a Fed policy requiring a doubling of these reserves will have a significant impact.

Another Look at Dodd-Frank

But let's return to Dodd-Frank. While there is Volcker language in it, the bill also says in Title VI, Sec. 619, (b)(1):

"Not later than 6 months after the date of enactment of this section, the Financial Stability Oversight Council shall study and make recommendations on implementing the provisions of this section so as to -- (A) promote and enhance the safety and soundness of banking entities. ..."

In short, the bill calls for federal financial regulators to study the measure, and then issue rules implementing it, based on the results of that study.

Just after the bill was enacted, I quoted a comment from an article by Binyamin Appelbaum in The New York Times on what will happen next:

    "...Brett P. Barragate, a partner in the financial institutions practice at the law firm Jones Day, estimated that Congress had fixed in place no more than 25 percent of the details of that vast expansion. ... Interest groups have been preparing for months.

    When the Consumer Bankers Association convened its annual meeting in early June, there was still plenty of time to lobby Congress. But the group's president, Richard Hunt, told his board that the group should shift its focus to the rule-making process. The board voted to increase the group's budget and staff.

    'Now we hope to have a good give and take with the regulators on the best interests of the consumer and the industry,' said Mr. Hunt. ... One clear consequence is a surge in the demand for lawyers with expertise in financial regulation, particularly those who have worked for regulatory agencies. Most of the major trade groups are hiring lawyers. The major banks say they are employing more, too."

So who will be on this Financial Stability Oversight Council? It will be chaired by the Secretary of the Treasury Geithner -- a tax cheat looking forward to a job in the financial industry. Other members: the Chairman of the Fed, the Comptroller of the Currency, the Director of the Bureau of Consumer Financial Protection Bureau, the Chairman of the Securities and Exchange Commission, the Chairperson of the Federal Deposit Insurance Corporation, the Chairperson of the Commodity Futures Trading Commission, the Director of the Federal Housing Finance Agency, the Chairman of the National Credit Union Administration Board, an independent member appointed by the president by and with the advice and consent of the Senate.

With the exception of Bernanke, this will be a group of politically driven bureaucrats. How long will the important provisions last? Not long. The only thing that might delay the weakening of the bill is the Occupy Wall Street Movement, if it re-gains traction.

What Dodd-Frank Missed: Eliminating Sales Commission for Banks

In earlier times, banks made money by getting paid more from lenders than they had to pay to attract deposits. In bankers' parlance, they made money on the spread (the interest rate on loans minus the interest rate paid depositors). Banks knew their survival depended on a positive "spread," so they were very careful to make low-risk loans. And after making them, they stayed in touch and worked with the borrowers to insure interest payments were kept up to date.

Everything changed when banks started selling off their loans. Instead of lending to low risk individuals and firms and worrying about how their borrowers were doing, banks focused on generating commissions by selling off their mortgages and other loans. This constituted a fundamental change in incentive structures -- from worrying about the soundness of their loans to writing as many loans as they possibly could for commissions.

Think about it: When loans are sold off, repackaged and sold off again, nobody knows (or cares unless payments stop) who the borrower is. As long as banks are allowed to sell off their loans for commissions, they will not make sound loans. Why should they?

In developing Dodd-Frank, Congressman Frank was concerned about this issue. His comment:

"As to managing their own loans...I did sponsor an amendment that was successful in our legislation that mandates the regulators to impose a risk retention requirement on any lender -- bank or non-bank. It will be 5% in most cases, although it can go to 10% for risky loans...."

Frank's amendment was removed from the bill before enactment. When loans are made to earn a sales commission, many will not be good loans.

A New Proposal

We are now worried about bank deposit safety and banks being too big to fail. In light of this, I offer a new proposal.

In 1933, Congress required that banks divest their trading arms. In 2012, perhaps Congress should insist that "investment banks" divest their banking arms. If you look at the four "banks" in Table 1, their investment and trading activities dwarf their deposit banking activities. We should require them to sell off their deposit banking activities.

Spin them off in IPOs. This is what investment banks are good at doing. And then require all depository institutions to manage their own loans and not engage in trading for their own accounts.

Elliott Morss is an economic consultant and an individual investor in developing countries. He has taught at the University of Michigan, Harvard University, Boston University, among other schools. Morss worked at the International Monetary Fund and helped establish Development Alternatives Inc. He has co-written six books and published more than four dozen articles in professional journals.

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