Magazine | March 6, 2017, Issue

Fixing Finance, Still

President Donald Trump signs an executive order to initiate a review of financial regulations, February 3, 2017. (Aude Guerrucci/MediaPunch/IPX/AP Images)
Replace Dodd-Frank with something that will work

Two weeks into his term, President Trump took on the Dodd-Frank law, President Obama’s 2010 attempt to reform the financial industry. “We expect to be cutting a lot out of Dodd-Frank,” the president said on February 3. The same day, he signed an executive order directing regulators to look through the nation’s financial laws to determine whether they conform to several key principles he has set out, including that they must “prevent taxpayer-funded bailouts.”

Trump is correct to revisit Dodd-Frank. This is a good example of his overall predicament: To right a private sector that has suffered from decades of government distortion, he must confront a deep regulatory state that is a self-contained economy of its own. The government entity that Trump has directed to revisit Dodd-Frank, the Financial Stability Oversight Council (FSOC), is itself a creation of Dodd-Frank. Would its staff counsel the president to eliminate their jobs?

It will take the FSOC 120 days — four whole months — to report back to the president. Consider that FDR signed into law the Securities Act of 1933, the country’s first major such law, less than three months after taking office. That much simpler law — still only 93 pages, even after decades of amendments — continues to serve the country well in preventing stock-market fraud.

Trump and his advisers are correct to intuit that Dodd-Frank did not end the “too big to fail” policy, and correct, too, to be concerned about this. Having large financial firms that are immune to marketplace discipline is bad for competition. Small and mid-sized banks are at a disadvantage, because they must comply with many of Dodd-Frank’s rules and restrictions without benefiting from the investor perception that the government would bail them out.

The persistence of “too big to fail” is a lurking political and social disaster, too. Trump won office in large part because, nearly a decade after the financial crisis, voters are still angry at the establishment politicians of both parties who protected investors in large financial firms even as they were oblivious to the personal cost of foreclosures and job losses.

One of President Obama’s main purposes in signing Dodd-Frank was straightforward. The law, he said during the White House signing ceremony, would “put a stop to taxpayer bailouts once and for all.” Nearly seven years later, though, we still have no evidence that the law has ended 2008-style bailouts of large financial firms, for the obvious reason that no large financial firm has failed since then.

Both commercial banks and investment banks continue to benefit from the extraordinary measures the government took after 2008. Record-low mortgage-interest rates, a key post-2008 government policy, have spurred tens of millions of people to refinance their homes or to purchase new homes, generating new fees for banks. Low interest rates have also enabled financial firms to profit from investments in government bonds and other supposedly low-risk instruments whose value goes up when rates go down.

Investment banks and brokerage firms had their most profitable year ever not in the boom before the crash, but in 2009. That year, their $61.4 billion in earnings more than made up for the $53.9 billion in losses they had experienced during the previous two years. They have continued to do well since.

There’s another reason it’s hard to judge Dodd-Frank’s effectiveness. The 848-page law required regulators to write 390 new rules. Rulemaking is not just a matter of writing a couple of lines of text, such as “Thou shalt not steal.” Rather, it is a matter of soliciting tens of thousands of pages of comments from industry players and anyone else interested in commenting, and then writing up thousands of pages of legalese. As of December, the General Accounting Office notes, more than six years into the Dodd-Frank regime, regulators had issued only about 75 percent of their rules, meaning that “the full impact of the Dodd-Frank Act remains uncertain.”

Even after the government has issued its rules, the outcome can remain unclear. One of Dodd-Frank’s major provisions to prevent bailouts, for example, is the “Volcker rule,” named after the Carter- and Reagan-era Federal Reserve chairman who suggested it. The rule, prohibiting a financial firm from making speculative short-term trades that could precipitate its failure and the government’s intervention to save it, seems like it should be easy to understand. But the final Volcker rule, along with the background information that the government thinks is necessary for sophisticated financial-industry workers to understand it, is 1,089 pages — yes, longer than Dodd-Frank itself. The rule attempts to cover every conceivable scenario: What if a bank buys a financial instrument for the long term but a regulator makes the bank sell that instrument in the short term? Should the firm be punished?

The Volcker rule also falls short because it requires regulators to determine the intent of traders at financial firms, not their actions. For example: Is a broker buying a bond because he thinks a customer might want to buy it tomorrow, or because he wants to make a quick buck by selling it back on the open market tomorrow? Attorneys at the law firm Davis Polk observed in January that “the intent-based focus . . . of the Volcker Rule is a fundamental flaw; discerning intent in a complex, rapid trading environment is effectively impossible.”

The fatal flaw of the Volcker rule, though, is that it seeks to prevent firms from failing in the first place. In a healthy free-market economy, firms will inevitably fail. The government’s goal should be to prevent their failure from infecting the rest of the economy.

On that front, there are reasons to be skeptical that Dodd-Frank can help regulators avoid bailouts of critically important financial firms — reasons that can be found both in the official mechanisms laid out for those regulators in the event of such failure and in regulators’ post-2008 behavior. The main way Dodd-Frank is supposed to avoid bailouts is through something new called an “orderly-liquidation authority,” which allows the government to seize a struggling financial firm rather than allow it to go through bankruptcy.

In bankruptcy, bondholders, lenders, and other investors could recover their money only if the firm’s assets had sufficient value. In orderly-liquidation authority, by contrast, the government can seize a financial company in danger of default, pump government money into it, and run it for three years, or five years if the government informs Congress that longer government management is necessary to preserve the company’s value or to protect the financial system’s stability. This gives the government extraordinary power to cushion the blow for investors in a failed firm. It can use taxpayer money from a Treasury-financed fund to lend to, or purchase the assets of, the afflicted company; to guarantee its assets against loss; and to assume its obligations.

Yes, even under Dodd-Frank, creditors and shareholders, eventually, are supposed to bear losses. But the government can favor some creditors over others, in its making of payments to them and other areas, if it thinks doing so is necessary “to maximize the value” of the firm’s assets. If the government cannot recoup the taxpayer money it has put into the failing firm, it can recoup it via an assessment on other large financial firms.

There is a lot wrong with this. Five years is a long time for the government to run, say, Bank of America. Because the Federal Deposit Insurance Corporation would run a failed financial firm, and because the president appoints the FDIC’s board, the president would have extraordinary control over a large part of the economy. And the government doesn’t have a good track record of figuring out what to do with the financial firms it already runs. It still hasn’t figured out what to do with Fannie Mae and Freddie Mac, the mortgage firms that it has run, under a mechanism similar to orderly-liquidation authority, for nearly a decade.

It is also not clear why the shareholders of other financial firms should have to transfer their profits to the investors in a failing firm. Such risk transfer isn’t just unfair and anti-capitalist. It could trigger a panic if several large firms were to come under liquidation authority all at once and investors in the surviving firms were uncertain that they could bear the losses of their fallen competitors at the same time as they dealt with a struggling economy.

Orderly-liquidation authority is complicated, and we can’t know how it will really work until there is an opportunity to see it in action. But there are already some indications that the government would be gentle with failing firms. Under Dodd-Frank, banks must create “living wills” to demonstrate how they could fail without harming the rest of the economy. But five big banks out of the eight that must endure such tests initially failed them last year. Wells Fargo has failed twice, the second time in December. That is, the government has decreed that, as of now, there is no way Wells Fargo could fail without unacceptably harming the rest of the economy, yet the firm still exists; the government has only told Wells Fargo that it cannot make certain acquisitions while it figures out how to pass the test.

Another problem is practical. The large financial firms are much bigger than they were before Dodd-Frank. In 2010, just as Dodd-Frank was passed, the nation’s seven largest banks — each with half a trillion in assets or more — each had, on average, a 7.39 percent share of the market. By mid 2016, the seven banks were down to six, and each had, on average, a 10.52 percent market share. Such concentration is bad for competition. Dodd-Frank would also make winding down the banks harder. If the government had to seize JPMorgan Chase, to whom, exactly, would it sell the bank, or its pieces?

The good news about big banks is that they have much more capital — money available to absorb losses — than they did a decade ago. Large financial institutions’ capital hovered below 7 percent of their assets, on average, before the financial crisis. Today, it is closer to 12 percent. But this isn’t necessarily good news about Dodd-Frank. Before Dodd-Frank became law, the Federal Reserve and other banking and securities regulators already had the authority to require banks to hold more capital. They didn’t need complex new legislation to exercise that authority.

Fixing Dodd-Frank’s too-big-to-fail shortcomings should be one of the Trump administration’s top priorities in addressing financial regulation. How to go about it? First, ask Congress to repeal the Volcker rule. It is a regulatory distraction, and it perpetuates too-big-to-fail rather than confronts it. After all, if the government has failed to stop a financial firm from short-term speculation that ends in its ruin, why isn’t the government also responsible for insulating investors from this failure? Unlike Obamacare, the Volcker rule will be missed by nobody if it is gone, except for all of the lawyers and compliance officers who have spent seven years working for it or against it.

Second, take a page from the House Financial Services Committee’s proposed Financial Choice Act, released last year and updated in February for the Trump era. Ask Congress to repeal Dodd-Frank’s orderly-liquidation authority and require large financial firms to go through the same federal bankruptcy code that other companies must. (Small depositors would keep the FDIC protection they have had since the FDR days without the need for wider bailouts of more sophisticated investors.)

Democratic members of Congress have an incentive to support these changes. In a financial crisis, they must ask themselves: Do we want Trump in charge, armed with all of the discretion that Dodd-Frank gives him to favor some financial firms and creditors over others and to run multitrillion-dollar banks for years on end under an utterly untested procedure? Or do we want the independent judiciary to oversee bankruptcies under tools and rules that worked well for decades before the politicians threw them away in favor of bailouts in the 2008 crisis?

– Nicole Gelinas, a Chartered Financial Analyst charterholder, is a senior fellow at the Manhattan Institute.

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