When the massive financial sand castle built on poor mortgage loans crumbled, first slowly, then quickly in the United States, Congress enacted the sprawling Dodd-Frank Act to overhaul financial regulation. One of its creations is the Consumer Financial Protection Bureau (CFPB), and one of the first things this new agency did was create a new mortgage disclosure based on simple principles. Research had found that almost no one could understand what they were signing when they took out a home loan, contributing to many defaults.
The idea is that understanding what a financial institution is telling you is critical to not only your financial health, but to the economy at large. That’s a point that law professor Frank Partnoy and financial journalist Jesse Eisinger make in our sister publication the Atlantic this week. They examine the financial disclosures of major banks, and particularly Wells Fargo, which investors believe is a “conservative” bank that emphasizes its vanilla lending business at the expense of riskier derivatives trading. But disclosures that should be simple were in fact totally opaque.
Perhaps we should be less surprised; in recent years, Wells Fargo has settled charges for racial discrimination in home-lending, for “robo-signing” mortgages during foreclosure litigation, and for selling mortgage-backed securities without understanding their risks. It’s the third-largest bank in the United States, not a credit union. Then again, Then again, Partnoy and Eisinger suggest that the fictional Bailey Building and Loan of the movie It’s a Wonderful Life is also a conservatively run institution, and we’ve already seen the audits there.
But their examination of the Wells Fargo’s annual report finds a web of opacity and confusion, and their questions to Wells Fargo spokespeople are not answered. They go through the various layers of complexity used to model the potential value of the bank’s assets and liabilities, and come up with a lot of blanks; here’s their interrogation of derivatives positions that the bank is supposedly taking on behalf of clients:
How much risk is the bank actually taking on these trades? For which customers does it place a requested bet, then negate its risk by taking an exactly offsetting position in the market, so that it is essentially acting as an agent simply taking a commission? And for all these trades, what risk is Wells Fargo taking on its customers? Many of these bets involve the customers’ promises to pay Wells Fargo depending on how certain financial numbers change in the future. But what happens if some of those customers go bankrupt? How much money would Wells Fargo lose if it “accommodates” customers who can’t pay what they owe?
That’s a lot of questions about huge amounts of money, and that much uncertainty about the financial system is correlated with a high risk for future crises.
Portnoy and Eisinger propose that the bank actually answer fewer questions and provide less, but clearer, disclosure. They harken back to times when rules were principle-based, and prosecutors put bankers in jail and there was a grand bargain: “Simpler rules and streamlined regulation if they subject themselves to real enforcement.”
However, it’s not clear why bankers would want simpler rules, when as, as the authors argue, they clearly benefit from complexity. They certainly don’t want real enforcement.
Take for example the authors’ solution to the Volcker Rule debacle—Congress’s effort to stop banks speculating with money insured by the government. Extensive legislative deliberation produced a 298-page draft version of the rule defining proprietary trading, which has been held up in regulatory limbo for years as lawyers, lobbyists, bankers and regulators debate what it should mean. Instead, Partnoy and Eisinger write,
Congress and regulators could have written a simple rule: “Banks are not permitted to engage in proprietary trading.” Period. Then, regulators, prosecutors, and the courts could have set about defining what proprietary trading meant. They could have established reasonable and limited exceptions in individual cases. Meanwhile, bankers considering engaging in practices that might be labeled proprietary trading would have been forced to consider the law in the sense [former Supreme Court justice] Oliver Wendell Holmes Jr. advocated.
Of course, regulators are already trying to define what proprietary trading means. It’s not clear why giving regulators and prosecutors more of the task, rather than democratically-elected representatives,would offer better results; the revolving door is as pernicious as the campaign donation, and prosecutors have not exactly covered themselves with glory prosecuting banks. As Felix Salmon of Reuters argues, the history of financial regulation is that it builds on what has gone before, and closing the Pandora’s box opened by US finance might be impossible.
The kind of principles-based regulation that the authors endorse offers virtues that America’s rule-bound system doesn’t. But it was in place in the UK when its banks began failing as well, and it could be hard to implement in a country like the US that prefers its government agencies underfunded. The CFPB and its new, simpler mortgage disclosure come from a principles-based approach that gave the agency wide leeway to work with financial institutions and less overt direction from Congress; its new form is also still hung up in the rule-making process.
The authors’ other suggestion is to focus on human responsibility, loosening the standards for securities-fraud prosecutions and holding executives personally responsible for the disclosures they sign, to create a real deterrent effect—one that isn’t replicated in the kinds of settlements regulators have forced on misbehaving banks. For that to work, we’ll still need regulators and prosecutors willing to take on major institutions. And I write “need” because if there’s one thing Partnoy and Eisinger demonstrate convincingly, its that the world’s financial institutions are still very dark and scary places.