POSC 335: A Case Study: Dodd-Frank Financial Reform
POSC 335 Final Exam: A Case Study
Following the financial crisis in 2008, the Dodd-Frank financial reform was passed in 2010 to help prevent giant banks from engaging in speculative trading activity. While speculative trading activity is not considered to be the cause of the financial collapse, many economists believe it was one of the contributing factors. While it is important for banks to support the economy by lending to consumers and businesses, they often become involved with proprietary trading. By making bets in exotic financial markets, proprietary trading, they are not really doing anything to support the economy but instead focusing on their own accounts. This habit tends to be risky and could lead to future government bailouts for these businesses deemed “too large to fail.” Ultimately, this Dodd-Frank reform was established to show that large corporations could either speculate on financial markets or have a government safety net; however, they …show more content…
cannot have both (Irwin, 2013). The issue that has arisen with the Dodd-Frank Act is how broad the language is. While the reform has established what banks must follow, it is more difficult to codify speculative activity into law, which is what regulators have spent the last few years attempting to do. In attempting to establish what qualifies as speculative trading, it’s important to understand why these practices are being limited. Speculative trading involves trading of future contracts, without intention of actually obtaining the underlying commodity. Instead, these traders will just resell the contracts before they reach the maturity date, resulting in profit from higher prices in the future markets where they resell these contracts. However, when these prices are increased too fast or demand is not met, there is no benefit to the economy. This lack of benefit to the economy and continually increasing price leads to a bubble effect. Adam Smith (author of An Inquiry into the Nature and Causes of the Wealth of Nations better known by its simplified name, The Wealth of Nations) explained that in reality, entrepreneurs seek profits not because their actions will benefit consumers. Their motive is clearly profit-maximization for their own benefit. The problem with market speculation arises when, as Smith stated in The Wealth of Nations, “When the profits of trade happen to be greater than ordinary, overtrading becomes a general error.” Ultimately, when banks engage in overtrading, if either the market or the funds dry up, the potential demise of some large banks because of bankruptcy rises to the forefront of public scrutiny (Smith, 1976).
As we learned in the 2008 crisis led by the housing market bubble, these eventually crash leaving the market crippled. When attempting to stop this speculation to prevent these bubbles, it becomes a complex task of determining what banks are allowed to do within realm of normal business. For example, banks are still allowed to be involved in hedging; protecting their current investments, and market making; raising costs to protect against future price increases. The main focus here is that banks must be monitored closely to ensure that they are not exceeding reasonable expectations and that they are not shifting risk to consumers and taxpayers (Irwin, 2013). The purpose of this study is to evaluate whether or not the Volcker Rule, as part of the Dodd-Frank financial reform, is able to prevent the proprietary trading that creates these asset bubbles. After evaluating the potential of the Volcker Rule, this study will show whether or not speculation has actually been reduced in the oil markets, which leads to higher prices per barrel. Multiple factors will be discussed in this study such as the influence of large banks to manipulate commodities because of their holdings in these areas, as well as the structural changes that have taken place that could influence speculation and trading. It is possible that there are more than just economic interests involved, perhaps political agendas that are driving forces in trading and price determination through factors such as production levels. The issues addressed in the study will be analyzed primarily through the Chicago School and the Stiglitz’ asymmetry of information theory.
Analysis and Results:
In his Nobel Prize Lecture: Information and the Change in the Paradigm in Economics (2001), Joseph E. Stiglitz argues that many of the major political debates over the past two decades have centered around one key issue: the efficiency of the market economy, and the appropriate relationship between the market and the government. The leader of one of the most powerful mass movements taught by the University of Chicago School of Economics was an economist named Milton Friedman. The Chicago School follows the theory of human nature that argues humans are all inherently selfish, and therefore, are motivated by extrinsic rewards. The Chicago school is also loosely based on the Protestant evangelical belief that the market is a divine system that rewarded those who worked and punished those who didn’t (Shareef, 2008).
In Dr. Reginald Shareef’s book, Free-riding and the Chicago School: Why MBAs Rule the World, he outlines the Chicago School’s ideology. The teachings revolve around “economic opportunistic theories that feature the iron triangle of free riding, third party players, and mandated default options (Shareef, 2008, p. 1).” Friedman’s free-riding opportunism teaches that all human beings are economic agents who attribute high importance to money and status and low importance to moral values, and organizations only exist to maximize profits for shareholders (Shareef, 2008).
One characteristic that distinguishes free-rider opportunism is the belief that lying, deception, and incomplete disclosure of information to gain economic advantage are acceptable. Stiglitz argues that the asymmetrical informational flow occurs where one party in a market transaction has important information that the other party does not have. He found that efficient market capitalism is based on symmetrical information flows where both parties have sufficient information to make enlightened economic choices. In contrast, the Chicago School teaches with the emphasis that profit maximization leads to efficient market activity, and asymmetrical information flows are necessary to achieve profit maximization. Managerial free-riders intentionally seek to create asymmetrical information markets by lying to gain competitive advantage (Shareef, 2008).
The Volcker Rule is a regulatory portion of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, and the last of the regulations to be voted on, passing in December of 2013 (Irwin, 2013). The idea is to prevent large commercial banks from losing their depositors’ funds as these banks speculate in exotic markets, which can result in a banking crisis, as it did in 2007-2008 through speculation in housing markets. Using the Chicago School of Economics theory, it can be inferred that these banks are using information gained from high-level depositors that can give them an unfair edge in commodities markets. However, if the information turns out to be false or misleading it can have dire consequences for those speculators and the citizens whose funds have been gambled away. The Volcker Rule intends to restrict this kind of artificial inflation of markets by forbidding this kind of speculation, thereby reducing the probability of a taxpayer bailout of these institutions, deemed “too big to fail.” Using the Chicago School Free Riding Opportunism analysis, it is obvious that these banks are looking to make some money for themselves off the backs of their depositors, and socializing any costs or losses incurred. It is, for all practical purposes, intended to prevent bank investors from gambling away other peoples’ money. The Volcker Rule is not intended to codify into law, but simply identify what is considered speculative or proprietary trading and ensure it is covered by existing provisions of Dodd-Frank, and it has taken three years to complete that. There is much argument between regulators and bankers over the thin line drawn between speculation and legitimate banking processes and bankers will be quick to defend their speculation as hedging (Irwin, 2013). The Volcker Rule requires banks to submit analyses proving that their securities holdings are actually hedges meant to protect themselves from a specific exposure in a specific market and difficult questions will be asked of the bank in response to this hedging. However, these rules will not go into full effect until July 2015, allowing the banks plenty of time to implement the regulations, which can be taken in two ways. First, this amount of time can be seen as giving the banks capability to either sell off any securities they possess which could be construed as speculative in nature; the second viewpoint is that this will give them plenty of time to make as much money as they can. Despite this, it would appear that these regulations, in place for a year, have had the desired result, specifically concerning the price of a barrel of crude oil. In the past year, financial giants Deutsche Bank and J.P. Morgan have removed themselves from the power and energy trading business, although eighty percent of these commodities are still handled by big banks (Eaton, 2013). There is another likelihood that needs to be explored, concerning the drop in oil prices worldwide. There is the possibility that it is based on international politics, specifically relations between the United States and Russia. The Organization of Petroleum Exporting Countries, led by staunch United States ally Saudi Arabia, voted not to cut production in the wake of falling prices. This can possibly be displayed as an attempt to stifle Russia’s economy, due to rising tensions between the two nations, which is two-thirds dependent on its oil and natural gas exports (Matlack, 2014). Since early August, the Russian ruble has fallen against the dollar and Euro approximately eight percent, which is remarkably close to the decline in price of oil (Matlack, 2014). As relations deteriorate between the two nations, specifically over the civil war in Ukraine, the oil cartel’s decision could be seen as being influenced by political interests versus financial interests. It is obviously not in OPEC’s best interests, at least from a financial perspective, to continue current production levels despite falling prices. It is therefore more likely that the Volcker Rule has absolutely nothing to do with the current price of oil on the global market and that political and strategic interests are, at least at this time in history, more important than financial interests. This theory is supported by the Chicago School of Economics, where asymmetrical information leads to efficient markets (Shareef, 2008). The common taxpayer will never truly know what is going on in the minds of the global elite, and how information is manipulated and distorted through mainstream media so that the regular person on the street never really knows what is truly going on in the world. As demonstrated in this study, speculative trading is often linked to the Chicago School of Economics’ theory involving asymmetrical information. By gaining insider knowledge as to what may happen in future markets and limiting the information accessible by other parties, large banking companies have been able to grow profits. These profits are likely evolving into bubbles, which will eventually crash, thus proving the need for the Volcker Rule. While the Volcker Rule has accomplished the desired results of limiting influence of large banks over commodities due to holdings, we can see it has not affected the price of oil. However, this is likely due to current political situations in which political interests are currently trumping financial motives. After these current political issues are resolved, it is likely that the Volcker Rule will have the same desired impact on the oil industry that it has had on the power and energy trading business in recent years.
Discussion:
Our group made the decision to divide the five components of the final paper between one another in pairs of two in order to allow more attention to be given to the individual portions of the essay and be as thorough as possible. In Rob and Kristen’s analysis portion of the essay the Dodd-Frank provision on the market was explored. More specifically, Rob and Kristin discussed the Volcker Rule, which set up a means to regulate the banks through the Dodd-Frank Wall Street Reform and Consumer Protection Act. Our group found that the Volcker Rule aimed to prevent the banks from making risky investments into parts of the economy such as the oil industry without any fear of the banks themselves suffering any losses, as any losses experienced would be the burden of the depositors in the form of tax payer funded bailouts.
In the recent past, the United States has experienced the repercussions of this risky behavior, speculative trading), which likely contributed to the housing market collapse in 2007-2008.
Our group found that the takeover of the Chicago School of thought was accompanied by the “free-rider opportunism” mentality. This mentality is distinguished by the belief that lies and deception to gain economic advantage is acceptable, and the strategy to privatize profit (to the private of public enterprise) but socialize costs (to the broader society). Similarly the “too big to fail” concept also came about with the Chicago School of thought which is the mindset that if an entity is big enough to effect the entire economy in its absence, then the government will have to bail them out if the entity was to fail. These notions incentivized risky investing practices, as there are few negative repercussions for those making speculative trades, which, in turn, led to inflammation and banking
crisis.
Conclusion:
One of the main issues our group has found with the Volcker rule is the fact that there are many discrepancies between the banks and the regulators in terms of what is considered speculative and what is not as there is not exactly a clear line between the two. Also, since the regulations of the Volcker Rule will not take full effect until 2015, it is unclear whether this will allow time for banks to comply with the new regulations in a reasonable amount of time, or only incentivize the banks to continue speculative trading while they can in attempts to maximize profits. Our group did however notice that some powerful banking entities such as J.P. Morgan have halted their trading in the energy business, which we found was a positive indication that the regulations will be beneficial to the United States economy.
References
Eaton, C. (2013, December 11). Volcker Rule could impede oil, gas price hedging. Houston Chronicle. Retrieved from http://www.mysanantonio.com/business/eagle-ford-energy/article/Volcker-Rule-could-impede-oil-gas-price-hedging-5056422.php
Irwin, N. (2013, December 10). Everything you need to know about the Volcker Rule, Retrieved December 6, 2014 from Washington Post: http://www.washingtonpost.com/
Matlack, C. (2014, October 13). Will Cheap Oil Choke the Russian Economy. Bloomberg Business Week. Retrieved from http://www.businessweek.com/articles/2014-10-13/oil-prices-are-hurting-russias-economy
Shareef, R. (2008). Free-Riding and the Chicago School: Why MBAs Rule the World. Blacksburg: Center for Public Administration and Policy, Virginia Tech.
Smith, A. The Wealth of Nations: Glasgow Edition of the Works of Adam Smith. Oxford, United Kingdom. Oxford University Press. (1976)
Following the financial crisis in 2008, the Dodd-Frank financial reform was passed in 2010 to help prevent giant banks from engaging in speculative trading activity. While speculative trading activity is not considered to be the cause of the financial collapse, many economists believe it was one of the contributing factors. While it is important for banks to support the economy by lending to consumers and businesses, they often become involved with proprietary trading. By making bets in exotic financial markets, proprietary trading, they are not really doing anything to support the economy but instead focusing on their own accounts. This habit tends to be risky and could lead to future government bailouts for these businesses deemed “too large to fail.” Ultimately, this Dodd-Frank reform was established to show that large corporations could either speculate on financial markets or have a government safety net; however, they …show more content…
cannot have both (Irwin, 2013). The issue that has arisen with the Dodd-Frank Act is how broad the language is. While the reform has established what banks must follow, it is more difficult to codify speculative activity into law, which is what regulators have spent the last few years attempting to do. In attempting to establish what qualifies as speculative trading, it’s important to understand why these practices are being limited. Speculative trading involves trading of future contracts, without intention of actually obtaining the underlying commodity. Instead, these traders will just resell the contracts before they reach the maturity date, resulting in profit from higher prices in the future markets where they resell these contracts. However, when these prices are increased too fast or demand is not met, there is no benefit to the economy. This lack of benefit to the economy and continually increasing price leads to a bubble effect. Adam Smith (author of An Inquiry into the Nature and Causes of the Wealth of Nations better known by its simplified name, The Wealth of Nations) explained that in reality, entrepreneurs seek profits not because their actions will benefit consumers. Their motive is clearly profit-maximization for their own benefit. The problem with market speculation arises when, as Smith stated in The Wealth of Nations, “When the profits of trade happen to be greater than ordinary, overtrading becomes a general error.” Ultimately, when banks engage in overtrading, if either the market or the funds dry up, the potential demise of some large banks because of bankruptcy rises to the forefront of public scrutiny (Smith, 1976).
As we learned in the 2008 crisis led by the housing market bubble, these eventually crash leaving the market crippled. When attempting to stop this speculation to prevent these bubbles, it becomes a complex task of determining what banks are allowed to do within realm of normal business. For example, banks are still allowed to be involved in hedging; protecting their current investments, and market making; raising costs to protect against future price increases. The main focus here is that banks must be monitored closely to ensure that they are not exceeding reasonable expectations and that they are not shifting risk to consumers and taxpayers (Irwin, 2013). The purpose of this study is to evaluate whether or not the Volcker Rule, as part of the Dodd-Frank financial reform, is able to prevent the proprietary trading that creates these asset bubbles. After evaluating the potential of the Volcker Rule, this study will show whether or not speculation has actually been reduced in the oil markets, which leads to higher prices per barrel. Multiple factors will be discussed in this study such as the influence of large banks to manipulate commodities because of their holdings in these areas, as well as the structural changes that have taken place that could influence speculation and trading. It is possible that there are more than just economic interests involved, perhaps political agendas that are driving forces in trading and price determination through factors such as production levels. The issues addressed in the study will be analyzed primarily through the Chicago School and the Stiglitz’ asymmetry of information theory.
Analysis and Results:
In his Nobel Prize Lecture: Information and the Change in the Paradigm in Economics (2001), Joseph E. Stiglitz argues that many of the major political debates over the past two decades have centered around one key issue: the efficiency of the market economy, and the appropriate relationship between the market and the government. The leader of one of the most powerful mass movements taught by the University of Chicago School of Economics was an economist named Milton Friedman. The Chicago School follows the theory of human nature that argues humans are all inherently selfish, and therefore, are motivated by extrinsic rewards. The Chicago school is also loosely based on the Protestant evangelical belief that the market is a divine system that rewarded those who worked and punished those who didn’t (Shareef, 2008).
In Dr. Reginald Shareef’s book, Free-riding and the Chicago School: Why MBAs Rule the World, he outlines the Chicago School’s ideology. The teachings revolve around “economic opportunistic theories that feature the iron triangle of free riding, third party players, and mandated default options (Shareef, 2008, p. 1).” Friedman’s free-riding opportunism teaches that all human beings are economic agents who attribute high importance to money and status and low importance to moral values, and organizations only exist to maximize profits for shareholders (Shareef, 2008).
One characteristic that distinguishes free-rider opportunism is the belief that lying, deception, and incomplete disclosure of information to gain economic advantage are acceptable. Stiglitz argues that the asymmetrical informational flow occurs where one party in a market transaction has important information that the other party does not have. He found that efficient market capitalism is based on symmetrical information flows where both parties have sufficient information to make enlightened economic choices. In contrast, the Chicago School teaches with the emphasis that profit maximization leads to efficient market activity, and asymmetrical information flows are necessary to achieve profit maximization. Managerial free-riders intentionally seek to create asymmetrical information markets by lying to gain competitive advantage (Shareef, 2008).
The Volcker Rule is a regulatory portion of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, and the last of the regulations to be voted on, passing in December of 2013 (Irwin, 2013). The idea is to prevent large commercial banks from losing their depositors’ funds as these banks speculate in exotic markets, which can result in a banking crisis, as it did in 2007-2008 through speculation in housing markets. Using the Chicago School of Economics theory, it can be inferred that these banks are using information gained from high-level depositors that can give them an unfair edge in commodities markets. However, if the information turns out to be false or misleading it can have dire consequences for those speculators and the citizens whose funds have been gambled away. The Volcker Rule intends to restrict this kind of artificial inflation of markets by forbidding this kind of speculation, thereby reducing the probability of a taxpayer bailout of these institutions, deemed “too big to fail.” Using the Chicago School Free Riding Opportunism analysis, it is obvious that these banks are looking to make some money for themselves off the backs of their depositors, and socializing any costs or losses incurred. It is, for all practical purposes, intended to prevent bank investors from gambling away other peoples’ money. The Volcker Rule is not intended to codify into law, but simply identify what is considered speculative or proprietary trading and ensure it is covered by existing provisions of Dodd-Frank, and it has taken three years to complete that. There is much argument between regulators and bankers over the thin line drawn between speculation and legitimate banking processes and bankers will be quick to defend their speculation as hedging (Irwin, 2013). The Volcker Rule requires banks to submit analyses proving that their securities holdings are actually hedges meant to protect themselves from a specific exposure in a specific market and difficult questions will be asked of the bank in response to this hedging. However, these rules will not go into full effect until July 2015, allowing the banks plenty of time to implement the regulations, which can be taken in two ways. First, this amount of time can be seen as giving the banks capability to either sell off any securities they possess which could be construed as speculative in nature; the second viewpoint is that this will give them plenty of time to make as much money as they can. Despite this, it would appear that these regulations, in place for a year, have had the desired result, specifically concerning the price of a barrel of crude oil. In the past year, financial giants Deutsche Bank and J.P. Morgan have removed themselves from the power and energy trading business, although eighty percent of these commodities are still handled by big banks (Eaton, 2013). There is another likelihood that needs to be explored, concerning the drop in oil prices worldwide. There is the possibility that it is based on international politics, specifically relations between the United States and Russia. The Organization of Petroleum Exporting Countries, led by staunch United States ally Saudi Arabia, voted not to cut production in the wake of falling prices. This can possibly be displayed as an attempt to stifle Russia’s economy, due to rising tensions between the two nations, which is two-thirds dependent on its oil and natural gas exports (Matlack, 2014). Since early August, the Russian ruble has fallen against the dollar and Euro approximately eight percent, which is remarkably close to the decline in price of oil (Matlack, 2014). As relations deteriorate between the two nations, specifically over the civil war in Ukraine, the oil cartel’s decision could be seen as being influenced by political interests versus financial interests. It is obviously not in OPEC’s best interests, at least from a financial perspective, to continue current production levels despite falling prices. It is therefore more likely that the Volcker Rule has absolutely nothing to do with the current price of oil on the global market and that political and strategic interests are, at least at this time in history, more important than financial interests. This theory is supported by the Chicago School of Economics, where asymmetrical information leads to efficient markets (Shareef, 2008). The common taxpayer will never truly know what is going on in the minds of the global elite, and how information is manipulated and distorted through mainstream media so that the regular person on the street never really knows what is truly going on in the world. As demonstrated in this study, speculative trading is often linked to the Chicago School of Economics’ theory involving asymmetrical information. By gaining insider knowledge as to what may happen in future markets and limiting the information accessible by other parties, large banking companies have been able to grow profits. These profits are likely evolving into bubbles, which will eventually crash, thus proving the need for the Volcker Rule. While the Volcker Rule has accomplished the desired results of limiting influence of large banks over commodities due to holdings, we can see it has not affected the price of oil. However, this is likely due to current political situations in which political interests are currently trumping financial motives. After these current political issues are resolved, it is likely that the Volcker Rule will have the same desired impact on the oil industry that it has had on the power and energy trading business in recent years.
Discussion:
Our group made the decision to divide the five components of the final paper between one another in pairs of two in order to allow more attention to be given to the individual portions of the essay and be as thorough as possible. In Rob and Kristen’s analysis portion of the essay the Dodd-Frank provision on the market was explored. More specifically, Rob and Kristin discussed the Volcker Rule, which set up a means to regulate the banks through the Dodd-Frank Wall Street Reform and Consumer Protection Act. Our group found that the Volcker Rule aimed to prevent the banks from making risky investments into parts of the economy such as the oil industry without any fear of the banks themselves suffering any losses, as any losses experienced would be the burden of the depositors in the form of tax payer funded bailouts.
In the recent past, the United States has experienced the repercussions of this risky behavior, speculative trading), which likely contributed to the housing market collapse in 2007-2008.
Our group found that the takeover of the Chicago School of thought was accompanied by the “free-rider opportunism” mentality. This mentality is distinguished by the belief that lies and deception to gain economic advantage is acceptable, and the strategy to privatize profit (to the private of public enterprise) but socialize costs (to the broader society). Similarly the “too big to fail” concept also came about with the Chicago School of thought which is the mindset that if an entity is big enough to effect the entire economy in its absence, then the government will have to bail them out if the entity was to fail. These notions incentivized risky investing practices, as there are few negative repercussions for those making speculative trades, which, in turn, led to inflammation and banking
crisis.
Conclusion:
One of the main issues our group has found with the Volcker rule is the fact that there are many discrepancies between the banks and the regulators in terms of what is considered speculative and what is not as there is not exactly a clear line between the two. Also, since the regulations of the Volcker Rule will not take full effect until 2015, it is unclear whether this will allow time for banks to comply with the new regulations in a reasonable amount of time, or only incentivize the banks to continue speculative trading while they can in attempts to maximize profits. Our group did however notice that some powerful banking entities such as J.P. Morgan have halted their trading in the energy business, which we found was a positive indication that the regulations will be beneficial to the United States economy.
References
Eaton, C. (2013, December 11). Volcker Rule could impede oil, gas price hedging. Houston Chronicle. Retrieved from http://www.mysanantonio.com/business/eagle-ford-energy/article/Volcker-Rule-could-impede-oil-gas-price-hedging-5056422.php
Irwin, N. (2013, December 10). Everything you need to know about the Volcker Rule, Retrieved December 6, 2014 from Washington Post: http://www.washingtonpost.com/
Matlack, C. (2014, October 13). Will Cheap Oil Choke the Russian Economy. Bloomberg Business Week. Retrieved from http://www.businessweek.com/articles/2014-10-13/oil-prices-are-hurting-russias-economy
Shareef, R. (2008). Free-Riding and the Chicago School: Why MBAs Rule the World. Blacksburg: Center for Public Administration and Policy, Virginia Tech.
Smith, A. The Wealth of Nations: Glasgow Edition of the Works of Adam Smith. Oxford, United Kingdom. Oxford University Press. (1976)