The scarring experience of the financial crisis of 2008, and the federal government’s actions to avert widespread chaos in the financial system, remain poorly understood events across the political landscape.
Although Congress enacted the Dodd-Frank Act in 2010 to prevent such crises from recurring, some of its provisions reflect that poor understanding. Rather than surgical precision, Dodd-Frank took an inefficient broad-brush approach to making the financial system safer. And despite being overly burdensome, it failed to address a range of issues, including the need to streamline the regulatory framework itself.
The Trump administration has said it wants to roll back the Dodd-Frank Act in the name of financial deregulation. And the House of Representatives may soon debate the Financial Choice Act — the most prominent proposal for the reform of Dodd-Frank — which was approved by the House Financial Services Committee earlier this month.
Although we laud the key goals of the Choice Act — to reduce onerous regulation, to make finance more efficient, and to end the too-big-to-fail problem — we believe that the proposal would make the financial system less safe.
The act is premised on the belief that Dodd-Frank undermined market discipline and made financial behemoths too big to fail when it required regulators to designate big banks and other large interconnected financial intermediaries as “systemically important financial institutions,” or SIFIs, that must be placed under stringent supervision. A second premise inherent in the Choice Act is that dropping the SIFI designation would eliminate bailouts of these institutions in a financial crisis.
But neither premise holds up to close scrutiny. In the 2008 crisis, the five large stand-alone investment banks (Bear Stearns Cos., Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., Merrill Lynch and Morgan Stanley) experienced bank-like runs because they had too little equity financing and were too illiquid. No one had yet dreamed of the SIFI designation, and no one was sure whether or how the federal government would act to stabilize the financial system. Yet, market discipline had not prevented these institutions from becoming sufficiently large, complex and interconnected that their failure threatened the entire financial system.
No act of Congress can credibly forbid a bailout in response to a financial crisis. A future legislature can simply alter the law, as Congress did in October 2008, when it enacted the Troubled Asset Relief Program (TARP). The U.S. Treasury Department then used TARP funds to recapitalize the country’s impaired financial behemoths.