The Great Bank Regulation Debate

Written By Briton Ryle

Posted July 21, 2014

Since the banking crisis of 2008-09, a major debate has been raging in Washington among elected officials and regulators. It all centers on just how free the banking system and investment markets should really be: Too much freedom increases the risk of another financial crisis, while too much regulation impedes economic growth.

While the Dodd-Frank Wall Street Reform and Consumer Protection Act which was signed into law by President Obama in July of 2010 has attempted to strike a compromise between the two extremes, the work is still not done. One area of the proposed Act still remains in contention, namely the amount of backing certain banking firms should receive from the government and taxpayers.

It seems everyone agrees that neither extreme is wise. Leaving the banks to simply roam free without accountability is clearly not safe, while the other extreme of loading them down with too many regulations would hinder any forward movement.

Perhaps the problem lies in the approach we are taking. All of the focus seems to be on the proactive side of catastrophe management, with everyone fighting over how much or how little regulation is healthy.

We may be focusing too much on one side of the equation and not enough on the other. There are two sides to catastrophe management – the proactive side and the reactive side. The debate in Washington seems to be all on the preventive side, with defenders wanting more regulation to prevent another crisis, while opponents want less regulation to increase profitability and growth.

But believe it or not, there is nothing wrong with moving some of the burden to the reactive side, in order to free up movement on the proactive side. Let’s take one example – “too big to fail”.

Painfully Slow Going

The Dodd-Frank Act covers a wide array of financial regulations designed to “create a sound economic foundation to grow jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and too-big-to-fail, and prevent another financial crisis,” the Senate Committee on Banking summarized the purpose of its bill.

As outlined in the Act’s summary, Dodd-Frank “ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses”.

The idea is that tightening up on the proactive side would leave less for the reactive side to handle.

To accomplish this tightening on the proactive side, the Dodd-Frank Act directed a great deal of its reforms at the Securities and Exchange Commission, calling for “increased transparency for the derivatives and asset-backed securities markets, and tougher rules for credit-rating firms.” So extensive these reforms are that after four years the SEC is far from finished.

“Only 44% of the SEC’s rules are final or nearly final,” informs law firm Davis Polk & Wardwell LLP. The Wall Street Journal reports that the SEC “has finished work related to oversight of the hedge-fund industry, protections for brokerage customers and a crackdown on conflicts of interest in state and local bond transactions,” but is “still working on issues at the heart of the financial crisis, including transparency regulations for the derivatives and asset-backed securities markets and tougher rules for credit-rating firms”.

The Act’s own authors are rightly frustrated with the slow progress. “Despite an initial rush to craft and implement regulations, the rule-making progress has slowed to a frustrating crawl, and agencies like the SEC still have far too many rules and regulations left to implement,” Mr. Dodd criticized the slow progress.

But to the extent that some of the Act’s recommendations have been put into practice, the other of the Act’s namesake, Former Representative Barney Frank, believes the measures have “already had an enormously beneficial impact” through the creation of the Financial Stability Oversight Council (FSOC) – which is charged “with identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States’ financial system,” as it outlines its mandate at its website.

One way the FSOC attempts to mitigate the risk of a failing bank taking down the entire banking system or even a large part of it is to designate certain banks as “systemically important”, which “subjects a firm to supervision by the Federal Reserve and a number of tougher regulatory standards”.

But while defenders praise the arrangement as a protection against the systemic failure of the banking industry, contenders argue it does no such thing, but only impedes growth.

New Banking Designation – Protects or Impedes?

Treasury Secretary Jacob Lew explained the need for the new designation at a recent congressional hearing. Prior to the new provision, “the existing regulatory structure allowed some large, complex nonbank firms to pose risks to financial stability that were not subject to adequate supervision,” Lew explained. The new designation thus clamps down on such excessive and unaccountable freedoms.

Representative Maxine Waters of California, the top Democrat on the House financial panel, expressed in a written statement her belief that the new designation along with other Dodd-Frank Act provisions have “provided much-needed oversight to Wall Street, given regulators the tools to end the era of ‘too big to fail’ entities and taxpayer bailouts and put a new federal agency on the front lines of protecting consumers from bad actors in the financial system.”

Yet House Financial Services Chairman Jeb Hensarling (R., Texas) expressed in a statement of his own that “in no way, shape or form does the Dodd-Frank Act end too big to fail”.

A report by the GOP due for release today contends that “the process created by the law for regulators to designate certain nonbank financial companies as ‘systemically important’ amounts to telling investors the government thinks those firms are too big to fail,” the Wall Street Journal informs.

The report warns that “these designations lead market participants to believe that they will be protected from losses if that firm fails”. Investors and other banks are thus likely to toss care to the wind and may take increased risk when dealing with such designated banks, only to find they will not be so protected when disaster strikes.

Other provisions of the Dodd-Frank Act attempt to contain banking failures before they infect the entire banking system by forcing the biggest banks to increase their capital reserves, enabling them to cover more of their own losses with less of the risk passed to the taxpayer. Contenders point out that the onerous measures leave banks with less capital to work with and generate profit from, stifling growth and profitability.

The Act also endows the FOSC with “orderly liquidation” powers to seize and dismantle a teetering firm if its bankruptcy would threaten the stability of the broader financial system – powers which are challenged by opponents as anti-free-market.

A Balance

The debate really centers on one basic dilemma… while increasing regulations reduces the risk of a financial crisis, it also reduces economic prosperity and growth. The debate thus will continue to rage, some opting for increasing, others calling for decreasing the Dodd-Frank Act’s impositions.

Yet this debate takes place on the proactive side of crisis management. While crisis prevention is definitely the place to start, there does exist another side which is not being addressed enough.

In addition to implementing some preventive measures, there also needs to be a reactive plan which spells out an emergency relief course of action in times of crisis.

This would shift some of burden off of the proactive side onto the reactive side of catastrophe management, alleviating some of the heaviness of regulations and allowing the markets and banking systems to move a little more freely during times of little danger.

Being too proactive overburdens you with precautions, completely impeding movement and progress. Yet, leaving it all to cleanup will slow progress because you’re busy fighting fires that have already started.

A balance between the two is required. While “too big to fail” is not wise, neither is having zero safety nets of any kind.

If we want the financial system to hum along at a faster clip, we must ease up on the regulatory weight imposed upon it. To do that, we must also allow for some kind of emergency relief measures on the post-crisis side of risk management.

In other words, we can neither overburden ourselves with a heavy suit of armor, nor spend all our time in hospital tending our wounds.

Joseph Cafariello

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