Choosing Financial Stability

Tomorrow the House Financial Services Committee moves to “mark-up” (amend and vote on) the Financial Choice Act, introduced by Committee Chair Jeb Hensarling.  The Choice Act represents the most comprehensive changes to financial services regulation since the passage of Dodd-Frank in 2010.  Unlike Dodd-Frank, however, the Choice Act moves our system in the direction of more stability and fewer bailouts.

At the heart of the Choice Act is an attempt to improve financial stability by increasing bank capital, while improving the functioning of our financial system by reducing compliance costs and over-reliance on regulatory discretion.  While I would have chosen a different level of capital, the Choice Act gets at the fundamental flaw in our current financial system: government guarantees punish banks for holding high levels of capital which, unfortunately, leads to excessive leverage and widespread insolvencies whenever asset values (such as houses) decline.  Massive leverage still characterizes our banking system, despite the “reforms” in Dodd-Frank.

The Choice Act also includes important, even if modest, improvements in Federal Reserve oversight (see Title VII).  There was perhaps no contributor to the housing boom and bust that has been as ignored by Congress as the Fed’s reckless monetary policies in the mid-2000s.  Years of negative real rates (essentially paying people to borrow) drove a boom in our property markets.  The eminent economist John Taylor has written extensively and persuasively on this topic, yet it remained ignored by legislators prior to Hensarling’s efforts.  Such reforms are too late to unwind the Fed’s current distortionary policies, but they may prove helpful in moderating future booms and busts.

Despite its daunting 500+ pages, the Choice Act is still best viewed as a modest step in the right direction.  Considerably more needs to be done to bring market discipline and accountability to our financial system.  But at least the Choice Act moves us in the right direction, for that the bill merits applause and consideration.