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Regulation and Compliance > Federal Regulation

A Step Backward in Financial Regulation

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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.

Now, we welcome the Choice Act’s recognition that adequate equity financing of financial institutions is crucial to limiting crises. But we fear that the level sought by the act — a 10% ratio of equity financing to the institution’s assets — is too low for the few truly systemic institutions. Further, that ratio is wholly insensitive to the riskiness of the institutions’ assets. And by cutting back on stress tests that gauge large institutions’ ability to weather a financial crisis, the act would make them and the broader financial system less robust to unexpected shocks.

Further, the act would limit federal regulators’ abilities to deal effectively with large institutions if they did get into financial difficulties, since the act would eliminate the institutions’ living wills (documents that provide a road map for an orderly shutdown) and the temporary financing needed to prevent creditor runs during the process of resolution.

The Choice Act also worsens one of Dodd-Frank’s key faults: the propensity to regulate by legal form rather than economic function. For example, the Choice Act largely ignores the possibility that non-banks engaged in bank-like activities could be a source of systemic risk. But recall that in 2008 those five large investment banks mentioned above were beyond the purview of bank regulation and were considered well-capitalized by their supervisor, the Securities and Exchange Commission. Similarly, Fannie Mae and Freddie Mac were giant mortgage securitizers that were outside the bank regulatory system. And today the money-market mutual fund industry — which needed federal guarantees to halt a run during the financial crisis — still doesn’t get proper oversight.

Finally, the Choice Act places additional limitations on the Federal Reserve’s ability to deal with any future financial crisis and imposes constraints on its wider role in setting monetary policy. Although the central bank must be held accountable, we believe that the act restricts the Fed in ways that would reduce the independence and effectiveness of monetary policy and circumscribe its role as lender of last resort.

To be sure, we support the Choice Act’s slashing of burdensome regulation. For example, the Volcker Rule, which bars a bank from making risky trades for its own account with depositors’ money, is far too complex and costly given its limited impact on systemic risk. Similarly, regulators can safely reduce the compliance costs imposed on most banks, which do not pose systemic risk, if they have adequate equity financing.

Nevertheless, the current version of the Choice Act would be a major step backward: It would make our financial system less safe than Dodd-Frank. There is still time for the House of Representatives to make changes that would promote safety and efficiency. We hope they do.