Congressional Republicans Take Aim at Dodd-Frank
The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in the wake of the 2007-2008 financial meltdown. Containing more than 2,000 pages and packed full of restrictions and regulations applied to the financial industry, Dodd-Frank was enacted in 2010 over the objections of Republicans who lacked the political leverage and public support to stop it.
Fast forward to 2016, where we find Congressman Jeb Hensarling (R-TX), the powerful chairman of the House Financial Services Committee, introducing the Financial CHOICE Act (Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs) as an alternative. The legislation aims to replace Dodd-Frank with a different set of regulations focusing on economic growth and accountability.
Does Dodd-Frank need to be replaced, overhauled, or simply left alone? Let's consider the objectives of Dodd-Frank, assess how well those objectives have been met, and whether the Financial CHOICE Act offers a reasonable alternative.
Meeting the Objectives?
In essence, Dodd-Frank was meant to lower the chances of future financial crises by making the financial system safer. At the same time, it attempted to make the system fairer, with an emphasis on protecting consumers and taxpayers. Hensarling's proposal suggest that the law’s safety factors are retarding growth, while its fairness factors are arbitrary and uncontrolled.
Dodd-Frank addressed financial system safety on multiple tracks, with a focus on larger institutions. Specifically, banks holding at least $50 billion in assets were designated as systematically important financial institutions (SIFIs) — institutions that could spark another financial crisis if allowed to fail. The Financial Stability Oversight Council (FSOC) was created to, among other tasks, decide whether to also designate certain non-bank financial firms as SIFIs.
SIFIs are subject to harsher regulations, including requirements to retain larger percentages of capital to avoid overextension, "living wills" to outline disposition strategy in case of failure, and "stress tests" that are created to simulate a future financial crisis.
Further actions addressed risky lending and trading practices. Regulations were placed on derivatives in an attempt to bring this shadowy market under more centralized control. Mortgage lending policies were enacted to restrict credit on riskier loans and limit the potential for mischaracterized loans. This was a central feature of Dodd-Frank, as mortgage securities with under-represented risk were a major factor in the 2007 financial meltdown. Within Dodd-Frank, the “Volcker Rule” further restricts banks from engaging in various risky and speculative investment activities in the search of their own profits (i.e. not for the benefit of the bank's customers).
Did all of this work? To some extent, it has. There has been no financial meltdown or any hint of one, and the balance sheets of major banks are far stronger today. However, Hensarling and others argue that safety has come at the expense of growth, creating a stalled economy. Republicans plan to put more risk management in the hands of the market.
Deregulation vs. Dumb Regulation
Hensarling refers to the root of the financial crisis not as deregulation, but instead as "dumb regulation." He contends that Dodd-Frank has encumbered the financial system by institutionalizing banks that are "too big to fail". By installing complex measures to prevent such banks from failing — while making them outline a plan in case of failure— the banks receive a mixed message and perform less capably
Meanwhile, initial results of the living wills and stress tests required by Dodd-Frank suggest that these banks are still living on the edge — in April, five of the eight major banks received a failing grade on their living will proposals.
Hensarling's approach is classic economic Darwinsim: If they deserve to fail, let 'em. Other major institutions have gone through bankruptcies before, and while short-term effects are painful, the financial system will go on. By effectively protecting the upper tier of big banks, he contends, Dodd-Frank is inadvertently concentrating their power, thus skewing the market. Smaller banks and credit unions that are unable to keep up with even their reduced regulatory requirements are dying off.
Under the Financial CHOICE Act, financial institutions would be given the choice to remain under Dodd-Frank control, or receive relief from many of the provisions by effectively self-insuring through raising and maintaining even higher capital requirements (voluntarily going beyond the established safety reserve limits). Investors bear the risk, not taxpayers, in the case of a failure. The "too big to fail" principle would end via a new subchapter of the Bankruptcy Code designed to handle larger failing institutions.
Maintenance capital requirements for banks would rise to 10% of assets. Larger banks may say thanks but no thanks because of the large amounts of capital they would have to raise, while smaller institutions may require little or no extra capital to meet the criteria to ease restrictions. To facilitate easier capital generation, the Volcker Rule would be repealed.
Stress tests will not go away, but they will be more transparent, clearly defined, and allow for public comment.
While risk is increased under this plan by opening up more investment options for banks, penalties for financial fraud will increase significantly. It's important for backers of the Financial CHOICE Act to draw a bright line between risky and illegal behavior.
CFPB or CFOC?
The Consumer Financial Protection Bureau (CFPB) stands a bit separate from the rest of Dodd-Frank, because of its focus on consumers and not the stability of the financial system — potentially creating conflicting goals.
By many accounts, CFPB has been highly successful in consumer-based reforms. It has returned well over $10 billion to consumers who have been victims of deceptive practices. However, the very thing that makes CFPB successful could be its downfall — its unique structure. CFPB is an independent agency run by a single director instead of a typical commission, and is funded outside of Congressional appropriations through the Federal Reserve. It is arguably not accountable to anyone.
The Financial CHOICE Act would redefine CFPB as the "Consumer Financial Opportunity Commission." The new agency would have a dual mission of protecting consumers and maintaining competitive markets, using cost-benefit analysis to make decisions. More importantly, a bi-partisan commission would be established to bring oversight and appropriations under Congressional control. Oversight is important, but right now it's an open question whether it's an improvement to have Congress in charge of it.
The Financial CHOICE Act may have some appealing points. Hensarling's Key Principles focus on economic growth, simplicity, accountability, and a balance of risk and reward. However, it isn't clear that the Financial CHOICE Act draws a sufficient boundary between risk and reward or between safety and growth any better than Dodd-Frank. Moreover, it’s uncertain how the Financial CHOICE Act would spark economic growth. Merely introducing easier capitalization does not create demand out of thin air. Controlled growth with solid economic underpinning — not financial manipulation — is the key.
For now, all this is moot in an election year, when bills are introduced more to generate political talking points than to advance real policy. Hensarling's proposal fits that pattern well. The Financial CHOICE Act serves as a marker for what could be accomplished under Republican control of both houses, a sympathetic President, and/or a veto-proof majority. That's highly unlikely under any scenario.
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