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If Dodd-Frank doesn’t work, here are four things that could

President Obama stands with Sen. Christopher Dodd (D-Conn.), center, and Rep. Barney Frank (D-Mass.), right, after signing the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21, 2010. (Charles Dharapak/AP)

A certain narrative about the Dodd-Frank Act, which celebrates its third anniversary on Sunday, is starting to get set in stone. This narrative, which Noam Scheiber laid out in a recent book review, is a little too self-satisfied about what was accomplished, and downplays the more aggressive ideas that were considered.

The final bill does look a lot like what the Treasury called for in its June 2009 white paper, "Financial Regulatory Reform: A New Foundation." But along the way, many ideas more aggressive than what ended up in the final bill were proposed, debated, and immediately dropped, or fizzled out with only a handful of votes. But these ideas influenced other parts of Dodd-Frank to make them better, while proposing an alternative story about what went wrong in 2008 and how to keep it from happening again. And it’d be a shame if they disappear down a historical memory hole.

Where do we draw the line?

One of the central questions in modern financial regulation is where to draw the line of permitted activities when it comes to banks. The New Deal separated investment banking from commercial banking, while rules solidified in the 1950s prevented bank holding companies from taking over banks in more than one state and from engaging in commercial activities. The bans on interstate banking, as well as the separation of investment from commercial banking, were removed in the 1990s. In the time frame between the repeal of Glass-Steagall (which separated investment and commercial banking) and the financial crisis, most of the debate was focused on commercial entities trying to open banks (e.g. Wal-Mart).

But since the crisis, there’s a whole new set of discussions over where to draw these lines. Activists were split between two possible ways to try and introduce walls. The first group wanted to place new restrictions on the activities in which banks, with their access to consumer deposits and the discount window, were allowed to participate. These ranged from preventing market making in swaps and other derivatives to reintroducing Glass-Steagall. This approach ultimately won out with the President adopting the Volcker Rule — which bans banks from trading for their own advantage, rather than on behalf of clients — in January 2010.

The second group looked at capping the size of the largest financial firms. There were practical arguments in favor of size caps, as smaller banks might be easier both to regulate and to let fail. But much of the argument focused on the idea that large banks were too powerful in a political sense. MIT economist Simon Johnson, in his widely read article from May 2009, "The Quiet Coup," argued that "old IMF hands" would look at our country and say "nationalize troubled banks and break them up as necessary." In order to prevent us becoming a banana republic where finance drives the economy from one crisis to another, there would need to be a "breaking of the old elite."

Both approaches had champions in the Senate. The size approach was represented by Brown-Kaufman’s SAFE amendment, which only received 33 votes in the Senate, including three from Republicans. The amendment would have capped bank assets and liabilities, with the practical effect of breaking up JPMorgan Chase, Wells Fargo, and Bank of America. The activities group was represented by Sen. Blanche Lincoln, whose "Section 716" would have forced banks to spin off their swaps and derivatives desks. This section was opposed by the administration and many leading regulators at the time, and was significantly weakened in the conference committee, but still survives in a limited form.

Radically simplifying derivatives

Derivatives regulation took a very similar path.

The process of reforming the massive over-the-counter derivatives market hadn’t even begun before people asked the obvious question: Why bother saving it? Isn’t radically shrinking it the correct response? This was a particularly big argument when it came to the type of financial instrument that imploded AIG: the credit default swap (CDS), an instrument where the buyer is compensated if the underlying loan fails.

Before the Treasury’s white paper came out, investor George Soros took to The Wall Street Journal to say, "Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds."

What he meant is that "naked" credit default swaps should be banned. A credit default swap pays out in the event of a default, which certainly makes it look like insurance. And as Wolfgang Münchau argued in the Financial Times at the time, a "universally accepted aspect of insurance regulation is that you can only insure what you actually own." They have to have an "insurable interest." Because of its classification as a swap, these CDS avoid all those regulations.

But just as Congress and the administration rejected the idea of ending big banks in favor of limiting what they could do, they also rejected the idea of ending dangerous derivatives in favor of trying to control them.

The Treasury opted not to ban naked CDS. Instead, they chose to put CDS sales through clearinghouses and pushed for price transparency. The arguments on derivatives during the passage of Dodd-Frank were generally around what kinds of derivatives would have to go through clearinghouses and what kinds of firms would have to follow these rules, the same battles that are ongoing in the rule-writing process.

But this did come to a head briefly in the Senate. Sen. Byron Dorgan (D-N.D.) had proposed an amendment banning naked credit default swaps, an amendment that looked like it wasn’t going to get a vote. Dorgan threatened a filibuster, which led the Senate to vote to table his amendment, 56-38.

But the idea hasn’t gone away. In a recent piece, "Against Casino Finance," in the conservative policy journal National Affairs, Eric Posner and E. Glen Weyl argue that conservatives should embrace the idea of the "insurable interest doctrine" in determining whether financial innovation is any good. Conservatives should change their narrative to one emphasizing the role of gambling in the crisis. By “blaming people who put the whole economy at risk to obtain riches they did not earn,” this new narrative “would allow conservatives to speak to what really enrages Americans about the financial crisis and Wall Street culture” while preserving actual innovation.

Vanilla and the Postal Bank

In keeping with Dodd-Frank’s "mend it don’t end it" spirit was its approach to offering consumers simple financial products.

In the Treasury’s original white paper, the new consumer protection agency could propose a set of "vanilla" financial products that were simple and straightforward . The agency would then, according to the Treasury white paper, be "authorized to require all providers and intermediaries to offer these products prominently, alongside whatever other lawful products they choose to offer." This would "tilt the scales in favor of simpler, less risky products while preserving choice and innovation."

The idea of a regulator forcing banks to offer specific products generated huge resistance and provided a rallying point for the Chamber of Commerce and the financial sector, which was preparing a big campaign to stop the consumer agency from getting off the ground. By October, Treasury had dropped it.

However, the vanilla products idea lives on. As University of Michigan law professor and former Treasury official Michael Barr, who was influential in developing the idea, told me, "with respect to mortgages, the qualified mortgages and qualified residential mortgage rules that ended up in Dodd-Frank are even stronger than what I proposed with vanilla products." These are rules for mortgages designed to steer the market to simpler, safer products. If they aren’t followed, lenders have great liability risks and have to retain risks if they are resold.

But the general idea that simpler products can form a behavioral anchor for the rest of the market could get a second life. More and more people are discussing the idea of government providing a simple, limited set of consumer financial products in the form of postal banking to help the unbanked (here’s an overview by David Dayen). Or, instead of placing the "vanilla product" inside of private banking companies, why not have the government provide vanilla products itself? Public provisioning is a form of regulation, and the government providing simple accounts itself might save on the regulatory headache. Call it a "public option" for finance.


The final major debate was how to handle the regulators. There were two directions this could have gone, neither of which were taken. One was to change the structure of the banking regulators themselves. Chris Dodd took the lead, and in the first version of his Senate bill, bank regulatory and supervision functions were removed from the Federal Reserve and other banking regulators and consolidated into a single mega-regulator to prevent regulatory races-to-the-bottom. This massive overhaul was quickly dropped. As with banks and derivatives, the administration opted to tweak regulators rather than blow them up and start over.

The second option was making the rules in Dodd-Frank more explicit. There were concerns from the get-go that regulators would write weaker rules than Congress intended, and that Congress should go ahead and write some stricter rules instead. This was particularly true with leverage requirements, where several members of Congress wanted hard minimum requirements written into the law. This ultimately did not happen either.

What next?

Recently, there have been several bills designed to go bigger on financial reform than Dodd-Frank did. One way to understand them is through this frustration with the regulatory process. The popular (if not Congressional) support for Elizabeth Warren’s Glass-Steagall bill can be read as a vote of no-confidence in the much delayed Volcker Rule. The Brown-Vitter capital requirements (which greatly limit the amount of debt banks can take on) are clearly a negative reaction against weak levels of leverage requirements coming out of the Basel negotiations. Brown-Vitter played a role in encouraging the FDIC to push for harder requirements; Warren’s Glass-Steagall bill could do the same for the Volcker Rule.

There are many pieces missing from this outline, ranging from taxes on the financial sector to reforming bankruptcy laws. But these debates are enough to tell a different story about the financial sector.

This story is skeptical of financial innovation. It posits that large amounts of raw gambling, as well as the sheer complexity and large size of the financial sector, are not doing very much good for consumers and the larger economy, and perhaps are even a net negative. The idea isn’t to bring transparency to the financial markets, but to scale them back.

But this story is also skeptical of regulators, and reflects a desire for Congress to rely less on regulatory micromanagement and more on bright lines that are easier to enforce. If Dodd-Frank fails, people will rush in with their stories of what went wrong. If and when that happens, we should remember that another path was possible.