Few people think the Dodd-Frank Act did much of anything to tame "too big to fail," and who can blame them.
The reform law provided three new tools to discipline the largest financial firms: orderly liquidation authority, living wills and the Office of Financial Research.
So far only the first two legs of that stool have gotten much attention. The third leg, the research office, is wobbly.
In the nine months since Dodd-Frank was enacted, the Obama administration has failed to nominate a director. It's reportedly considering accomplished academics — Andrew Lo at MIT and Bob Shiller at Yale are two under consideration — but for now the research office is being run by the Treasury Department's Office of Domestic Finance.
Adam LaVier is its point man as the Treasury's acting director of the office of research and quantitative studies. LaVier came to the department in May 2009 from the law firm Morrison & Foerster and spent 10 years at Citigroup doing economic and financial market research.
In an interview Wednesday, LaVier said the administration considers the search for its first director to be "a very high priority."
Allan Mendelowitz urged Congress to create the research office, and claims it can save the government from ever facing another decision like the one presented in fall 2008 by Lehman Brothers.
"You no longer will have a situation where the secretary of the Treasury makes monumental decisions about what happens to institutions in the capital markets in total ignorance of the conditions of the markets or what the consequences are going to be," said Mendelowitz, a former director at the Federal Housing Finance Board.
"We are talking about fixing a major hole in understanding what's going on in the markets in a way that will hopefully prevent policymakers from making disastrous decisions like that."
Simply put, the Office of Financial Research is supposed to spot the next crisis before it's too late. It's supposed to figure out what data the government needs to assess financial system risk and then standardize its reporting so information from dozens of firms can be aggregated. It's supposed to analyze the data it collects and send up flares when it sees risks getting out of hand.
"We want regulators, when something does happen, to understand the problem so the remedy they are proposing is a scalpel and not a sledgehammer," LaVier said. "Everybody is better off, and I think that's an important capacity that the OFR brings to the table."
By providing the public with detailed nonconfidential data on financial markets, LaVier said, it should improve market discipline. "We are viewing the OFR as a force multiplier," he said. "The OFR succeeds not simply because regulators get smarter but because market discipline improves."
So far, the office's only public effort is a project to assign an identity to each legal entity within a financial company. This "legal entity identifier" will help the office build a standardized data base that will eventually allow the government to know how parts of companies interact with each other and with counterparties at other companies. Some 30 groups replied to the office's November 2010 proposal, and LaVier said some final decisions should be made this summer.
The research office is to support the 15-member Financial Stability Oversight Council, another Dodd-Frank creation. The council is chaired by the Treasury secretary and includes federal and state regulators from various financial sectors. The research office's director is a presidential appointment, confirmed by the Senate for a six-year term. The director gets a nonvoting seat on the council, and is to testify before Congress annually on the state of the financial system.
For the first two years, the Fed is to finance the research office. After 2012 it will fund itself, through an assessment on large firms. President Obama's budget projects its costs will be $50 million to $60 million by the end of the 2012 fiscal year; it's expected to have a full-time staff of about 230 by then.
The research office holds a key to getting both orderly liquidation authority and living wills right.
In Dodd-Frank, Congress extended the Federal Deposit Insurance Corp.'s power to take over and liquidate banks to any firm deemed to be systemically important, and it told the FDIC and the Federal Reserve Board that they must require all these companies to submit plans detailing how they should be wound down if they get into trouble.
The information generated by the Office of Financial Research will help the FDIC get a better handle on any failing company and, in particular, its connections to other firms. It also will help both the FDIC and the Fed figure out if a living will submitted by a large company makes sense.
As the research office gets organized, the other agencies are forging ahead and asking the big firms to supply more data about their operations. Each of the agencies now has its own unit dedicated to large companies.
Industry sources say the agencies are asking for different information or the same information, formatted differently. It's understandable that the regulators are proceeding, and equally understandable that institutions are frustrated by the duplicative requests.
But this is not what Congress mandated. It wanted a single entity — the Office of Financial Research — to gather and analyze data from all the institutions that pose a threat to financial stability.
"The single best thing to come out of the bill is the OFR," said Eugene A. Ludwig, the CEO of Promontory Financial Group and comptroller of the currency in the Clinton administration. "But it has one nasty flaw: it should not be in Treasury. It should be independent."
The Treasury may indeed be part of the problem, if for no other reason than that its staff is stretched thin and it has a number of more pressing problems, like getting the debt ceiling raised to avoid a government default.
But the big financial firms share some of the blame. Self-preservation dictates opposition to the provisions in Dodd-Frank designed to curb their size or complexity. It's in their interest for investors, counterparties and customers to assume the government will continue to bail out large companies that get into trouble.
"Each institution has an incentive to keep its balance sheet complicated, to not standardize how it reports data, to push against market utilities that could in fact make systemic risk less," said Vince Reinhart, former director of the Fed's division of monetary affairs who is now a resident scholar at the American Enterprise Institute. "The OFR could be an important counterpoint to that."
But the industry's biggest players may be making a mistake.
Plenty of politicians, not to mention community banks, continue to bang on the "too big to fail" drum. If another large firm stumbles, the pressure to crack down will intensify and it's an easy bet that Congress will take harsher steps than those in Dodd-Frank.
"One of the biggest risks the industry faces is another crisis," said John Liechty, a statistics professor at Pennsylvania State University who with Mendelowitz was part of the group calling for the research office's creation.
"The political costs will be extremely high."
Big firms could be broken up or face size or growth limits. Special taxes could be imposed on systemically important firms or they could be forced to pay into a fund that would cover the costs of future bailouts. The Volcker Rule could be strengthened and commercial and investment banking could be separated again. Capital requirements could be jacked up even further.
In other words, doesn't it make sense to see if the research office, living wills and beefed-up resolution powers can lead to effective oversight of the largest financial firms? If Dodd-Frank's tools aren't given a chance to work, the industry may find that what comes next is much more disruptive.
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