When upheaval struck the financial markets starting in 2007, chief financial officers absorbed much of the impact, whether they worked on Wall Street or Main Street. Dodd-Frank was adopted in 2010 as a response to the upheaval, and in the five years since, the financial world has seen its share of Dodd-Frank critics.
But we believe that CFOs will find that the law makes their jobs easier — if not obviously so in the short-term, then almost certainly so in the future.
Few CFOs who were around in 2007 have forgotten the disruption of the asset-backed commercial paper market. That was one of the earliest manifestations of the crisis, well before Bear Stearns came to the brink and more than a year before Lehman Brothers declared bankruptcy and the federal government rescued AIG. This $1.2 trillion source of financing for companies across the economic spectrum shrank by 30% in just the second half of 2007, and while much of the damage was seated in subprime mortgage asset-backed commercial paper, many other CP issuers experienced bank-like runs, and companies across the economy lost important financing.
CFOs also know that when banking institutions were imperiled by the broadening crisis in 2008, banks husbanded long-term funding and short-term liquidity alike. And then came the grave trauma suffered by the economy as a whole. All of these developments challenged CFOs.
The 25-year period known as the “Great Moderation” — a unique period of low macroeconomic volatility starting in 1982 — was accompanied by both significant financial-market deregulation and great financial-market innovation, which together set the stage for the “Great Recession.” The congressionally chartered Financial Crisis Inquiry Commission (FCIC) found the causes of the crisis to be failures in regulation and supervision, faulty corporate governance and risk management practices, speculative risk-taking, excessive leverage, opacity and complexity of derivatives markets, failures of credit-rating agencies, and breakdowns in accounting and ethics.
Dodd-Frank was a necessary and, in most respects, capable response to these findings. Although we don’t believe all parts of the 2,000-page statute should have been adopted — for example, both the Volcker Rule and the new limitations on Federal Reserve lender-of-last-resort powers were mistakes (the latter a particularly troubling one) — the core provisions of Dodd-Frank serve to address the causes of the financial crisis that the FCIC (among others) cited.
These core provisions will reduce the likelihood that the financial system and the U.S. economy will again experience the conditions that gave rise to the crisis and strengthen the long-term stability of the global financial system, and they will promote sustained economic growth in the United States. This macroeconomic and financial stability should be good news for corporate America’s CFOs.
At the Core
Dodd-Frank mandated enhanced capital and liquidity requirements for our largest banking organizations, an important step toward ensuring that the financial system’s most significant players never need to bow out of the game. Dodd-Frank also mandated that those banking organizations submit to stress-testing and demonstrate their ability to weather financial market difficulties. Importantly, the Federal Reserve has instituted an additional stress-testing regime to ensure that our largest banking organizations have strong balance sheets. Dodd-Frank also required important steps toward identifying non-bank organizations and non-banking activities that create systemic risk.
When liquidity drained from the commercial paper market in 2007, other short-term financing markets — such as the repo market — followed suit. In related events, dozens of sponsors of money market funds needed to support their bank-like deposit-taking activities. Later, when Lehman failed — in large part because it experienced a run by its repo financing counterparties — the federal government had to step in with bank-like deposit guarantees to prevent a run on money-market funds.
In response, Dodd-Frank mandated important liquidity requirements for a range of financial-market participants. There is little doubt that these requirements — and related actions by the SEC with respect to money market funds and by the Federal Reserve with respect to the tri-party repo market — have restricted liquidity and have likely made the jobs of CFOs more difficult in the short term. But we believe that markets will find a new equilibrium.
We do not mean to say that current regulations governing liquidity should now be set in stone. Far from it. If there is one place where the multiplicity of new requirements has had a cumulative and complex effect, it is in the realm of liquidity. This should surprise no one — CFOs least of all — since the financial crisis was, first and foremost, a liquidity crisis (as financial crises tend to be). But the interactive, compounding effect of the requirements — the liquidity coverage ratio, the net stable funding ratio, mandates for stronger margining of derivative transactions and, perhaps, repo and other short-term funding transactions, and the various speed bumps and detours introduced into the roads traveled by securitization transactions — will take years of data collection and analysis to understand fully.
As that understanding develops, adjustments should be considered and implemented. But it would be unwise to assume that any such adjustments will cause market liquidity to return to levels experienced during the unconstrained days before 2007. In the meantime, our financial system will be safer than it was at the advent of the crisis.
The opacity and complexity of the derivative markets drove much of the run-like behavior that affected the financial markets. Market participants didn’t know where the risk of sub-prime mortgages had roosted, and this circumstance resulted in no small part from the spreading of risk through credit default swaps — which was accompanied by a surprising concentration of the risk through these instruments as well. Dodd-Frank has ensured greater transparency in the derivatives market and greater financial strength of significant market participants.
Dodd-Frank also shored up the balkanized financial regulatory and supervisory structure and reduced the opportunity for regulatory arbitrage by consolidating one financial regulator with another, concentrating consumer financial protection in a single financial regulator, and establishing a council of regulators, the Financial Stability Oversight Council (FSOC), with a mandate to monitor and counteract systemic risk.
For the first time, the U.S. regulatory system has a regulatory body specifically charged with identifying and monitoring financial market risk, gaps in regulation and threats to financial stability, promoting market discipline, sharing information among its members, and designating systemically important non-bank financial institutions for enhanced supervision by the Federal Reserve if their demise would threaten the financial stability of the United States.
For CFOs caught in the cross-hairs of the FSOC, there is no doubt that their lives are more complicated. For the system as a whole, the FSOC should serve as a stabilizing force and help to iron out conflicting regulatory regimes where mandates overlap.
Financial regulation has always been — and must always be — an iterative process. Markets and market participants are far too complicated for any significant legislative effort to be entirely right when first adopted. There can be little doubt that, five years later, some Dodd-Frank reforms are in need of reform themselves.
But the core reforms should remain because they contribute fundamentally to the systemic stability of our financial markets and thus to the broader economy itself. We resist the reflex of putting the financial markets in one corner and the “real economy” in another — and, although we started out above with a reference to Wall Street and Main Street, we resist the distinction. The concepts are too easily twisted into political narratives that defy efforts to rationally address and improve financial regulation.
We believe CFOs and their kin will understand this better than most, whether they guide the financial affairs of a firm engaged primarily in financial activities or in the myriad other economic activities that make up the American economy.
George W. Madison is a partner in, and William A. Shirley is counsel at, Sidley Austin LLP. During the financial crisis, Mr. Madison served as general counsel of the U.S. Treasury Department (2009-2012), and Mr. Shirley served as general counsel of AIG Financial Products Corp. (2007-2011).
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.