Hot Topic – Rethinking Dodd-Frank: Opposing views from two leading policy experts

“Dodd-Frank is a disaster,” the President of the United States told reporters on 30th January as he signed an executive order slashing government regulations. “We’re going to be doing a big number on Dodd-Frank,” President Trump said. “The American dream is back.” Later that same week, the Director of the National Economic Council, Gary Cohn, announced that yet another executive order for the review of financial regulation was a “table-setter for a bunch of stuff that’s coming.”

The SWIFT Institute interviewed Hester Peirce, Senior Research Fellow and Director of the Financial Markets Working Group, at the Mercatus Center at George Mason University and Aaron Klein, Fellow in Economic Studies and Policy Director of the Center on Regulation and Markets, Brookings Institute to try to figure out what some of that “stuff” might be from the perspectives of opposing views from two leading policy experts based in Washington DC.

Dodd-Frank Report Card

We asked if the US financial sector was in a much safer place today than before the crisis as a result of Dodd-Frank. Peirce responded, “I think that the 7-year report card has not been so good for Dodd- Frank. What is particularly worrisome are OTC derivatives clearinghouses in that these ‘too big to fail’ entities pose a new potential weakness in the financial system. Generally, there has been a more regulatory-centric approach with regulators being asked to do a lot more, and make more decisions. But because it has fallen to the regulators rather than market forces to manage all the risk in the system, I think the next crisis could actually be even more intense.”

Klein outlined a different point of view, saying, “It is unequivocally, factually accurate that the US and global financial regulatory system is substantially safer today than it was a decade ago. Greater capital underlies the financial system, tougher oversight among insured institutions secures the system, and new regulatory agencies monitor the activities and products offered in the system. These reforms were all made in aim of trying to prevent the same toxic combination of products and incentives and financial jiu jitsu which allowed the 2008 financial crisis.”

Peirce and Klein did agree however, that there was a clear appetite across the board for regulatory reform of Dodd-Frank, regardless of political affiliation. “In my opinion, there is not much of Dodd-Frank that works particularly well, so I would recommend a ‘soup to nuts’ relook of the regulation. Most people recognise Dodd-Frank needs to be changed, the question is how much can actually be done given the very simplified narratives that have sprung up around the reform debate. People are currently correlating the willingness to reform Dodd-Frank with being a proponent of the financial system crashing again.”

Klein concurred on the need for change, saying, “Dodd-Frank did not come down on stone tablets from Mount Sinai to be the unaltered gospel truth for all time. But I think the current political environment in
the US is not a sane and rational discourse. Before Dodd-Frank, I went back almost 100 years and all of the financial regulatory reform bills were passed on a bipartisan basis. But in the case of Dodd-Frank, largely bipartisan or even Republican-based ideas were codified into the statute, and yet in the end the decision was made by Republicans to near-unanimously oppose the legislation. It was this refusal to compromise that made it harder to go back and improve the legislation.”

On the agenda?

Overall, Peirce believed that any change to financial regulation should be a chance to rejig the financial system in order to ensure growth in the economy. Reforms should be made to address present problems, for example, the fact that companies are staying private for longer because it is currently less attractive to go public in the US. Investors are being shut out from participating in gains of those companies as a result, and companies are finding it more difficult to grow.

She also believed that there would be changes regarding the manner in which US regulators interact with their international counterparts on capital and globally systemically important financial institutions. “In the US we have much more of a notice and comment process when it comes to regulation, rather than a straightforward implementation of what international regulators have agreed upon beforehand. This is especially true with regards to designation, for example, when companies are designated as systemically important simply because a group of international regulators has decided they should be. It just doesn’t sit too well. So I think we’ll see some changes there,” Peirce explained. “Furthermore, there is a danger when companies are designated as systemically important because this essentially provides a promise to the financial system that the government will never let those entities fail, and that is very disruptive.”

Lastly, she believed that changes would be made to assist smaller banks in dealing with the level of difficult compliance work associated with the federally mandated rules, including those stemming from Dodd-Frank.

Rather than the designation of systemically important financial institutions (SIFIs), Klein focussed on the SIFI thresholds which were set out under Dodd-Frank as an arbitrary dollar amount, not indexed for economic growth or inflation. “The regulation ended up creating this counterweight system of penalties to size and growth, but in that process people were guessing as to what the right size threshold should be for various penalties to be put into place. Some they got right, some they got wrong,” observed Klein.

Klein also believed that it would be wise to consolidate financial regulators. “The system created three new regulators under Dodd-Frank, and this follows a historic trend whereby after every financial crisis, the US adds new regulators,” he explained. “Eventually the sheer growth and number of regulators will itself prove a weakness of the financial regulatory system.”

Volcker Rule
When it came to the issue of the controversial so-called Volcker Rule that restricts US banks from making certain kinds of speculative investments that do not benefit their customers, Peirce felt a relook was needed. She noted the concerns that have arisen surrounding the role that the Volcker rule might be playing with regards to the liquidity in the bond market, and if in times of market stress, the rule might end up actually harming the market. She believed that the goal of ensuring that taxpayers do not end up funding risk taking, could rather be achieved by imposing adequate levels of equity capital within banks. These would not only act as a natural constraint on risk taking, but would also act as a natural absorber of these losses if they do occur.

Klein was pessimistic that any eventual change to the Volcker rule would be made, simply because it would require the exceedingly difficult task of having five different financial regulators agree on a common rule. He preferred to focus on the implementation of the rule instead: “We can complain about how the Volcker Rule is being implemented, but it is very hard to fix that through legislation itself. It might be better to get the regulators to agree on a better implementation solution. Neither of these, however, are easy processes.”

Consumer Financial Protection Bureau

Peirce and Klein were diametrically opposed when it came to the future of the Consumer Financial Protection Bureau (CFPB). Peirce did not believe there would be any need to have a separate agency that would deal with consumer financial protection and that these issues could instead be handled by the Federal Trade Commission and the banking regulators. “It is a very problematic structure that the agency has now,” Peirce expounded. “We have seen such a troubled first five years with the CFPB that it really is going to be a difficult one to reform. It has used its resources in ways which are questionable. A regulator and an enforcement agency could potentially do a lot of good examining the real problems in this area, but the CFPB has spent its time on things that arguably are not even in its jurisdiction and has been very unwilling to take due process considerations into account. Consumers are not better off as a result of the CFPB.”

Klein adamantly disagreed, “The CFPB is an incredibly important entity that has provided direct and tangible benefits to millions of American consumers. The CFPB is not only here to stay, it is a fundamentally good idea. There are always ways in which any agency can evolve to do its job better, but with regards to if the CFPB is doing a good job and is its job incredibly vital to the well-functioning to the financial system and to the American public’s trust in the financial system? The answer to both is absolutely. The government’s position is vital in ensuring this element of trust within the financial system.”

Future financial crises

Overall, Peirce believed that Dodd-Frank as it currently stands, has the potential to foster long-term instability within the financial system. This was due to the emphasis on regulators making an increasing number of decisions, meaning that if a regulator were to make an unintentional mistake, the severity of the problem would be increased as it would affect everyone across the entire financial system. Liquidity rules, whilst well-intentioned, could also amplify a problem during a financial crisis when companies
would be in need of liquid assets. Title II, which creates a new alternative to bankruptcy for some large financial institutions, adds a further measure of uncertainty because it would not be clear if counterparties would be going through a Title II or not. And of course a problem within a clearing house would clearly reverberate throughout the entire financial system. “I am not questioning the intentions of the people who came up with these rules,” justified Peirce. “I think that everyone is aiming toward the same goal, which is to make sure that problems are contained and managed. It is just a question of whether those tools will actually work the way they were intended.”

Klein believed the build-up to a next financial crisis would potentially be the fault of having too many regulators. “One of the problem is regulatory arbitrage, by which in the quest for leverage, speculative activity finds the most permissive regulator,” said Klein. “During the build up of the last financial crisis, there was the former Office of Thrift Supervision, combined with an unregulated mortgage lending and securitisation system, and a lax SEC that allowed tremendous leverage among stand alone investment banks, and a broken insurance regulatory system that allowed completely unregulated activity. The US system’s panoply and plethora of regulators makes it more potentially possible for regulatory arbitrage.”

Conclusion

Peirce was optimistic over the chances of at least some change being implemented to current financial regulations, citing the fact that there is interest from the House of Representatives, the Senate and the President. “Realistically speaking, it is less likely that we are going to rip out Dodd-Frank root and branch and start all over,” she said. “We also have to take into consideration that firms have invested a considerable amount in complying with all the existing rules, so there is some understandable pressure for policy-certainty.”

Klein, on the contrary, pinned hope on change to the implementation process instead of reform to the legislation itself. “Fortunately Dodd-Frank provides the regulators substantial discretion to implement the legislation. It is through wisely implemented regulation that we can perhaps fix some of the problems that congress are unable to solve.” One fact that both sides can agree on is that without a well-functioning financial system, everyone is going to suffer. We live in interesting, and some would say unpredictable, political times. Calling the future of Dodd-Frank is anybody’s guess.

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