In the old days, you sat down to a card game if the pot was worth the cost of the candle it would take to light the table. As the Dodd-Frank Act turns five years old, the question remains whether it was worth the candle.
Banking laws can reshape our financial system. The Banking Act of 1933, in response to the 1929 stock market crash, created a dual system of commercial banks and investment banks that greatly changed the financial system. The dual system proved ineffective when investment banks established money market funds to make inroads into traditional banking. As a result, commercial banking organizations were permitted to engage in underwriting and dealing activities. The dual system may not have prevented another crash, but leaving it in place would have led to a financial system dominated by shadow banks.
The Dodd-Frank Act also is reshaping the U.S. financial system. That is worth the candle if the Act prevents or at least tempers the next financial crisis.
But crisis-inspired banking laws should be limited to addressing the source of the crisis. There is little consensus as to the source of the 2008 financial crisis. For some, it was a credit crisis spurred by banks making, packaging, and reselling high-risk mortgages. Others see it simply as a market liquidity crisis. Still others blame low interest rates, the housing bubble, the credit rating agencies, inadequate supervision by financial regulators, and/or the lack of adequate protections for consumers. These and other factors may have played a contributing role. But is a law addressing each necessary to avoid a future crisis?
That seems an overreaction. It is, however, the Dodd-Frank Act approach, replacing flexible supervision of banks with rigid regulation. The Act’s provisions were hailed by many as vital to promoting a safer, more stable financial system. But how many of the provisions in its 15 separate titles be worth the candle in the long run?
For example, the Act established wholly new and untested compliance regimes for activities that may or may not have played a role in the crisis. Implementing and remaining in compliance with these new regimes is costly and time-consuming. Title VII requires licensing and compliance with trading, margin, and clearing requirements for swaps activities. If indeed the new regime eliminates any threat to U.S. financial stability, these requirements could well create new threats. For instance, the swaps-clearing requirement has led to the creation of central counterparties that may themselves pose a systemic risk in a liquidity crisis such as the one in 2008.
The Volcker Rule provisions of the Dodd-Frank Act prohibit a banking entity from engaging in proprietary trading or investing in or sponsoring a private equity or hedge fund. Few have pointed to such activities as central causes of the 2008 crisis. Yet the Volcker Rule, with all of its ambiguities, requires banking entities to implement and maintain excessively onerous requirements. Less draconian ways of dealing with trading and fund activities were not discussed. Some banks may decide to exit these businesses rather than bear the increased costs. Not worth the candle? Seemingly so, given the threat of less liquid and more concentrated trading and fund markets.
Causes for Concern
The Dodd-Frank Act presents two major concerns. The first is that, in the short run, compliance costs will be too great and have a significant adverse impact on the financial condition of all but the largest banking organizations. The second is that, in the longer run, increased supervisory and regulatory restraints will cause banking organizations to curtail or exit certain businesses, with a resulting greater shift to the less-well-regulated shadow banking system.
The Act’s central tenet is to protect financial stability by having no “too big to fail” banks that the government would need to bail out in a crisis rather than allow to fail. All of this is focused on a bank’s asset size without any strategic focus on optimal financial structure or the costs and benefits of a banking system with larger banks.
Supervision by banking regulators historically bore a direct relationship to the bank’s risk profile. Congress substituted hard-and-fast regulations for supervisory discretion. Instead of leaving discretion to banking regulators, Congress chose to set out a laundry list of required enhanced standards. It will take an act of Congress to put out each of these candles now that they have been lit.
The cost of compliance with the enhanced standards is disproportionately higher for smaller “systemic” banks and ignores the value these banks bring to the U.S. economy as an important source of financing to small and medium-sized businesses and the housing market. Will it be a safer U.S. financial system if substantial added compliance costs hamper the effectiveness of small and mid-sized banks that no one has suggested are too big to fail? To be worth the candle, shouldn’t the Dodd-Frank Act be fixed so that any compliance burden bears a direct, not inverse, relationship to a bank’s risk profile?
The enhanced standard requiring “systemic” banks to maintain a “living will” for how their operations would be wound down or sold in the event of its failure is another good example of the laundry-list approach. The exercise is beneficial in that it requires a bank to review its overall structure and operations. It is hard to imagine, however, that banks and regulators will, or should, follow these play books in an unanticipated, severely adverse scenario. Perhaps a smaller candle is needed.
The Dodd-Frank Act seeks to eliminate taxpayer bailouts. However, is limiting a central bank from acting as lender of last resort in times of crisis worth the candle? The Federal Reserve, as the U.S. central bank, used this authority to provide liquidity in the 2008 crisis. The European Central Bank has done the same for EU banks. Providing needed liquidity can avoid a potential domino of bank liquidity failures that result from marking banks’ books to market. The Dodd-Frank Act does not eliminate, but restricts, the lender of last resort authority. Is the requirement to seek Congressional approval in the midst of a crisis that demands immediate response the way to protect U.S. financial stability?
The laundry-list standards also may conflict with internationally agreed-upon standards. International coordination of the supervision of banks has been in place for many years and serves to maintain competitive equality among internationally active banks. The Dodd-Frank Act, however, requires non-U.S. banks doing business in the United States to comply with uniquely U.S. standards in addition to home-country standards based on the international standards. That may prove a deterrent to non-U.S. banks opening or keeping offices in U.S. cities.
Laws that sacrifice jobs and potentially weaken the robustness of the economy should be carefully limited to ensure that the United States remains the major financial center.
A law in the face of a financial crisis may be necessary to restore public trust. Shouldn’t a law, enacted without exhaustive review, be limited to addressing direct causes of the crisis?
The risk in the Dodd-Frank Act’s expansive approach is that the law creates more potential threats to U.S. financial stability than it eliminates.
Ernest T. Patrikis is head of the bank and insurance advisory practice at law firm White & Case LLP. He is a former general counsel and chief operating officer of the Federal Reserve Bank of New York.