Why Dodd-Frank won’t prevent another financial crisis.
After Obama became president... it took Congress more than two years to pass Dodd-Frank, named for former senator Chris Dodd of Connecticut and former congressman Barney Frank of Massachusetts, the sponsors of the law in each house. The law takes up 849 pages—that’s more than twice as long as the 407-page stimulus law and only 57 pages shorter than the Obamacare legislation. By contrast, the Sarbanes-Oxley law of 2002—Congress’s post-Enron attempt to fix financial markets—is just 66 pages. Going further back, the Securities Act of 1933—a cornerstone of financial regulation that helped prevent meltdowns for five decades, until financial lobbying began to erode its power—runs just 93 pages. The Glass-Steagall Act, another 1933 law that separated long-term commercial banking from shorter-term investment banking, ensuring that the risk of one activity didn’t infect the other, totaled 53 pages. And even after decades’ worth of amendments, the Securities Exchange Act of 1934 adds up to only 371 pages.
That Dodd-Frank tried to do too much at once is evident not only in its length but also in its mind-numbing complexity and vast scope. Dodd-Frank addresses everything from how to achieve “financial stability” to how to wind down failing firms through an “orderly liquidation authority” to how to regulate derivatives as well as mortgages. Almost as an afterthought, the law creates an enormous new bureaucracy, the Bureau of Consumer Financial Protection. The CFPB, as it’s commonly known, is so potentially consequential that its sponsors should have introduced it as a separate piece of legislation (see “Dodd-Frank’s Protection Racket,” Summer 2012). (...)
Dodd-Frank’s biggest failure is to have perpetuated too big to fail. The cataclysm of 2008 proved that Washington was terrified to let large or complex financial firms go bankrupt. But bankruptcy is a natural, healthy occurrence in a capitalist system. The goal should have been to figure out how to allow these firms to go under. Dodd-Frank’s approach, by contrast, was to make the world safe from bankruptcies, not for them. “Dodd-Frank kills the capitalist system,” says Rosenblum bluntly.
Dodd-Frank’s command-and-control ethos is epitomized by the Financial Stability Oversight Authority, a ten-member regulatory group that will “identify risks to the financial stability of the United States,” “promote market discipline,” and “respond to emerging threats to the stability of the U.S. financial system.” But these three things don’t go together. The FSOC’s work in monitoring the nation’s largest financial institutions contravenes its mandate to ensure market discipline. Why should investors monitor big firms if the government is already doing it for them? “As soon as a financial institution is designated as systemically important” by the FSOC, Dallas Fed president Richard Fisher told the House financial-services committee this June, “it is viewed by the market as being the first to be saved.” The SIFIs—the law’s “systemically important financial institutions”—thus “occupy a privileged space,” Fisher added.
Such privilege makes it exceedingly difficult for free markets to reverse a decades-long trend. In 1990, Fisher notes, the nation’s four biggest banks had $519 billion in assets, or 9 percent of gross domestic product. By 2011, they had $7.5 trillion, or 50 percent of GDP. “We have a structure that is not a free-market structure,” concurs Thomas Hoenig, vice chairman of the FDIC. “It is heavily subsidized”—at least $83 billion annually in artificially cheap borrowing costs, according to a Bloomberg View analysis. Further, if the FSOC misses a big risk and a firm fails because of this oversight, whose fault is that? Congress has ensured that it is the government’s fault just as much as the firm’s—hardly a blow for market discipline. (...)
The law also imposes a burden on large or complex financial firms that contravenes what should be their paramount duty: to protect their own investors from loss. Dodd-Frank mandates not only that systemically important firms protect themselves but also that they protect the rest of the financial system and the economy from “systemic risk.” But as Peirce notes, “no one knows what that is.” If a firm’s bankruptcy triggered a 10 percent stock-market fall, would such an outcome be too systemically risky to accept? The government “should want institutions to think of their own risks,” says Peirce, who previously served as senior counsel to Senator Richard Shelby’s staff on the Senate banking committee. The current approach “sounds very grand and important,” she says, “but what matters is what individual actors are doing.” How can the government expect financial firms that can’t foresee their own future losses to predict the losses of other firms and how they might harm the economy?
After Obama became president... it took Congress more than two years to pass Dodd-Frank, named for former senator Chris Dodd of Connecticut and former congressman Barney Frank of Massachusetts, the sponsors of the law in each house. The law takes up 849 pages—that’s more than twice as long as the 407-page stimulus law and only 57 pages shorter than the Obamacare legislation. By contrast, the Sarbanes-Oxley law of 2002—Congress’s post-Enron attempt to fix financial markets—is just 66 pages. Going further back, the Securities Act of 1933—a cornerstone of financial regulation that helped prevent meltdowns for five decades, until financial lobbying began to erode its power—runs just 93 pages. The Glass-Steagall Act, another 1933 law that separated long-term commercial banking from shorter-term investment banking, ensuring that the risk of one activity didn’t infect the other, totaled 53 pages. And even after decades’ worth of amendments, the Securities Exchange Act of 1934 adds up to only 371 pages.That Dodd-Frank tried to do too much at once is evident not only in its length but also in its mind-numbing complexity and vast scope. Dodd-Frank addresses everything from how to achieve “financial stability” to how to wind down failing firms through an “orderly liquidation authority” to how to regulate derivatives as well as mortgages. Almost as an afterthought, the law creates an enormous new bureaucracy, the Bureau of Consumer Financial Protection. The CFPB, as it’s commonly known, is so potentially consequential that its sponsors should have introduced it as a separate piece of legislation (see “Dodd-Frank’s Protection Racket,” Summer 2012). (...)
Dodd-Frank’s biggest failure is to have perpetuated too big to fail. The cataclysm of 2008 proved that Washington was terrified to let large or complex financial firms go bankrupt. But bankruptcy is a natural, healthy occurrence in a capitalist system. The goal should have been to figure out how to allow these firms to go under. Dodd-Frank’s approach, by contrast, was to make the world safe from bankruptcies, not for them. “Dodd-Frank kills the capitalist system,” says Rosenblum bluntly.
Dodd-Frank’s command-and-control ethos is epitomized by the Financial Stability Oversight Authority, a ten-member regulatory group that will “identify risks to the financial stability of the United States,” “promote market discipline,” and “respond to emerging threats to the stability of the U.S. financial system.” But these three things don’t go together. The FSOC’s work in monitoring the nation’s largest financial institutions contravenes its mandate to ensure market discipline. Why should investors monitor big firms if the government is already doing it for them? “As soon as a financial institution is designated as systemically important” by the FSOC, Dallas Fed president Richard Fisher told the House financial-services committee this June, “it is viewed by the market as being the first to be saved.” The SIFIs—the law’s “systemically important financial institutions”—thus “occupy a privileged space,” Fisher added.
Such privilege makes it exceedingly difficult for free markets to reverse a decades-long trend. In 1990, Fisher notes, the nation’s four biggest banks had $519 billion in assets, or 9 percent of gross domestic product. By 2011, they had $7.5 trillion, or 50 percent of GDP. “We have a structure that is not a free-market structure,” concurs Thomas Hoenig, vice chairman of the FDIC. “It is heavily subsidized”—at least $83 billion annually in artificially cheap borrowing costs, according to a Bloomberg View analysis. Further, if the FSOC misses a big risk and a firm fails because of this oversight, whose fault is that? Congress has ensured that it is the government’s fault just as much as the firm’s—hardly a blow for market discipline. (...)
The law also imposes a burden on large or complex financial firms that contravenes what should be their paramount duty: to protect their own investors from loss. Dodd-Frank mandates not only that systemically important firms protect themselves but also that they protect the rest of the financial system and the economy from “systemic risk.” But as Peirce notes, “no one knows what that is.” If a firm’s bankruptcy triggered a 10 percent stock-market fall, would such an outcome be too systemically risky to accept? The government “should want institutions to think of their own risks,” says Peirce, who previously served as senior counsel to Senator Richard Shelby’s staff on the Senate banking committee. The current approach “sounds very grand and important,” she says, “but what matters is what individual actors are doing.” How can the government expect financial firms that can’t foresee their own future losses to predict the losses of other firms and how they might harm the economy?
by Nicole Gelinas, City Journal | Read more:
Image: Arnold Roth
