This is the first article in a two-part series on potential regulatory changes for the financial services industry. Read Part 2 here.
The Dodd-Frank Act and the many thousands of pages of regulations and legal undertakings that followed its 2010 passage have put the U.S. financial sector under greater constraint than at any time since the Great Depression.
In the aftermath of the 2008 financial crisis, politicians in both parties focused on punishing banks and other financial services companies for a variety of offenses, real and imagined. In many respects, Dodd-Frank was designed to chastise banks and other companies for perceived wrongdoing, especially abuses of consumers.
How will the Trump administration deal with this legacy and the broader questions of financial regulation?
Trump Changes the Narrative
Perhaps the biggest change for financial services companies and professionals in 2017 is that the political narrative regarding financial regulation has shifted from a punitive, anti-business focus to a more traditionally conservative agenda focused on growth and jobs.
Christopher Whalen Financial services
An important point to make regarding the regulatory response to the 2008 crisis is that liquidity, not a lack of capital, was the proximate cause of the catastrophe. Yet since 2008, regulators and policy makers have tried to prevent a future crisis by focusing on increasing banks’ capital and limiting their ability to take risks.
Any changes to the current regulatory system need to de-emphasize the mechanistic use of capital as a catch-all response to the financial crisis. Instead, policies should be constructed to prevent financial fraud, particularly the use of hidden leverage to enhance short-term financial returns.
When deception is used to conceal risk, the eventual revelation of that risk causes investors to react with surprise and fear, and rush for the exit. Systemic risk is when markets are caught unawares, as in the cases of last year’s Brexit vote in the United Kingdom and the failure of Lehman Brothers in 2008. When such systemic events occur, the cost of credit intermediation increases dramatically, decreasing market liquidity and the effective leverage in the global economy.
The 2008 failures and government bailouts for Citigroup, American International Group, Fannie Mae, and Freddie Mac resulted not from a lack of capital, but rather from a sudden change in confidence regarding these institutions. These rescues caused enormous anger among the public, rage that was whipped into a fever pitch by the home-foreclosure crisis that dragged on for nearly seven years.
Politicians at the state and local level used the rubric of “consumer protection” as an excuse to extract billions of dollars from the shareholders of public and private companies via fines, lopsided legal settlements, and other expenses related to remediation of alleged violations of law.
Meanwhile, virtually no executives of the major U.S. banks and financial institutions were subjected to legal sanctions for acts of financial fraud and malfeasance. Instead, victims of the 2008 crisis — namely the shareholders of the largest financial institutions — have been repeatedly punished.
The fact that the Bush and Obama administrations were unwilling to prosecute the officers and directors of large, bad banks involved in obvious acts of fraud has set a troubling standard for public policy. In particular, during Obama’s presidency, the Justice Department determined that regardless of what laws they broke, the big banks were too integral to the global economic system to prosecute criminally.
That has generated waves of public resentment against banks and bankers alike that arguably affected the results of the recent U.S. election.
A 2014 report by the Financial Crisis Inquiry Commission (FCIC) detailed numerous acts of fraud and chided the Federal Reserve and other regulators for failing “to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.”
The FCIC noted correctly that protecting consumers is not solely about avoiding abuses in the lending process, but also enforcing the laws against fraud in the financials markets. The managers and owners of small banks and non-banks are subject to the full force of the law, but the officers and directors of the largest institutions are essentially given a free pass.
A Fairer Approach
With the change in government in Washington, the focus on punishing the shareholders of financial institutions will gradually change to a more even-handed approach that will be reflected at all levels, from agency heads to examiners working in the field.
One leading example is a likely change to the prosecutorial mindset of the Consumer Finance Protection Bureau (CFPB).
Since the passage of Dodd-Frank, the CFPB has departed from its past practice of issuing rules and instead has regulated via lawsuits and enforcement actions, generating enormous anger from the various constituencies in housing and other sectors.
That approach likely will yield to a more sensible one that tries to balance public policy objectives with fairness.
Christopher Whalen is chairman of Whalen Global Advisors and a former senior managing director for Kroll Bond Rating Agency.
This article is a shortened version of a policy brief originally published by the Networks Financial Institute at Indiana State University.
