BCBLE Lecture Series: Eugene Ludwig on Putting Dodd-Frank in Context

On February 24, the Berkeley Center for Law, Business and the Economy (BCBLE) hosted a lunch presentation featuring Eugene Ludwig, founder and CEO of Promontory Financial Group. In his talk titled “Financial Regulation in the Post Reform Era: Putting Dodd-Frank in Context,” Ludwig shared his perspectives on the Dodd-Frank Act and other regulation efforts within the context of earlier cycles of crisis and reform. He discussed what the changes mean for the evolution of the American regulatory model and the transformative potential of the financial services industry. 

Ludwig had a “front row seat to the crisis.” He described the tense Sunday afternoon after the collapse of Lehman Brothers. It looked highly likely that in a series of events, Morgan Stanley would fail the following Monday, Goldman Sachs on Tuesday and General Electric on Wednesday. Had it not been for the Federal Reserve’s decision to allow Morgan Stanley and Goldman Sachs to convert into traditional bank holding companies, “the financial system, as we know it, would have collapsed.” He recalled “literally [writing] the application on the back of typing paper” to fend off the near-catastrophe in a moment that exposed the incredible vulnerability of the financial system.

The recent crisis may be “slowly fading in the rearview mirror,” but Ludwig believes public impressions of the panic are just as cloudy as they were five years ago. In his view, part of the difficulty of singling out a cause is that much responsibility lies with a pervasive “deregulatory or self-regulatory atmosphere.” The presence or lack of rules was less significant than the “tone” set by the government.  For example, prior to the crisis, regulatory organizations had the tools to limit unsound or unsafe developments. Moreover, the crisis was foreseeable: “Go look at the Case-Shiller Home Price Indices.” The index was virtually flat from 1945 until 2003 when all of a sudden it skyrocketed. Ludwig believes the financial bubble, as evidenced by the “camel hump” on the set of data, was apparent as early as 2005. Yet, there was little regulatory response.

Ludwig described in detail his disagreement with at least one view that the 2004 change to the SEC rule, which “permitted broker dealer subsidiaries to increase their leverage,” was a primary cause of the crisis. He outlined some of the reasons for his stance: First, the notion that this rule somehow unleashed the leverage ratios at Wall Street firms overlooks the tremendous amount of leverage allowed prior to the 2004 decision. Leverage ratios may have risen in the aftermath of the 2004 rule, but leverage had skyrocketed before the rule took effect as well. Second, a number of companies with the highest leverage ratios were not covered by the new regulation. The SEC’s hope to drain business back into the regulated sectors was flawed mostly because the agency never took advantage of its supervisory role. 

Ludwig acknowledged that there is “a lot of good” in Dodd-Frank and other government efforts to address problems in the industry. However, as the rules and regulations drafted in the wake of the crisis are gradually becoming established law, “one can take some discomfort in the fact that systemic risk and the possibility of another major crisis has not been eliminated.” He identified some of the “big holes” in Dodd-Frank and other reforms, including the complete lack of regulation of the shadow banking system and lack of rules to address the role of mortgage brokers in the industry. These gaps leave major factors of systemic risk wholly unaddressed.

So where does this leave us? Ludwig outlined his hopes for financial reform moving forward. First, he asserted the importance of strong consumer protection laws as he discussed the risky lending practices of the preemption sector in the 1990s. He explained the lack of supervision is a theme that has consistently undermined the industry; thus, the “supervisor [doing] the supervising” will make for a safer financial system. Second, Ludwig argued for a single financial regulatory structure. The current multi-regulatory structure breeds inefficiencies, actually encouraging rather than preventing crises. Furthermore, Dodd-Frank leaves us with a plethora of different regulators regulating in different ways and this “basically leaves institutions to choose their regulators.” Third, Ludwig expressed hope for more scholarship investigating the major questions that influence regulation so that commentary is based on a degree of “scientific” insight absent today.

Ludwig concluded his presentation reflecting on the potential for finance to advance development within the U.S. and around the world. Ludwig stressed the importance of “getting the balance right” between regulating sufficiently and minimizing crises on one hand and overregulating on the other. He explained overregulation could stunt business ideas and innovations that enhance well-being and stability. For example, as U.S. Comptroller of the Currency under President Clinton, Ludwig led efforts to reform the Community Reinvestment Act (CRA) to facilitate the availability of credit to low and moderate income Americans. Responsible lending produced results where credits tended to be safer. However, subsequent regulations have cut a whole swath of low and moderate income groups out of the financial system because they can’t afford a 20% down payment. He explained the dangers of a system that is so locked down that innovation is shunned. Mr. Ludwig extended this discussion to the global context as well, commending the innovations of Muhammad Yunus and the Grameen Bank. Finally, Ludwig reiterated his belief that overly controlling banks as the “bad guys” can do more harm than good by overlooking some of the “good things finance is all about”: a shared sense of values, respect for rule of law and a “common language that can advance solutions for all of mankind.”