July marked the fifth anniversary of passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Not surprisingly Washington celebrated with numerous events and Congressional hearings. I put in three Congressional testimonies myself, as well as numerous panel appearances, ranging in venues from the American Enterprise Institute to the Center for American Progress. One of the many impressions I walked away with is that badly needed substantial reforms of our financial system will be impossible to pass into law until we get past Dodd-Frank. I’ve also come to the conclusion that the only way to really get past it is full repeal.
One might ask, but wouldn’t repeal leave our system vulnerable and take us back to financial crises? And indeed that would be the crucial question, if its premise of Dodd-Frank having addressed the crisis were correct. Such a premise, however, is not correct. The weight of the evidence suggests to me that the recent crisis was driven largely by a boom and bust in our nation’s property markets, particularly housing, and that our current system of financial regulation linked the performance of the housing and mortgage market to our capital markets in such a manner as to result in a significant disruption when the value of housing and mortgages declined. Key ingredients of this crisis were: exceptionally loose monetary policy, supply rigidities in our property markets, extensive international capital flows into the US (and US mortgage market), extensive policy encouragements for both high corporate and household leverage and extensive moral hazard created by various government guarantees.
The Act did give a nod to crisis related issues like mortgage underwriting and the role of rating agencies, but for the most part, it did not address drivers of the crisis or addressed them in an ineffective manner. Of course the next crisis may look considerably different. The Volcker rule, for instance, was defended by Paul Volcker as not about the last crisis, but about the next one. Despite the almost tautological claim that every crisis is different, in truth a wealth of empirical data suggests crises have a lot in common. They almost always involve some combination of easy money, high leverage on property, moral hazard from government guarantees and international capital flows. These have largely been unaddressed in Dodd-Frank.
Some elements of Dodd-Frank may actually make financial crises worse. For instance concentrating derivatives risk into a few large entities is likely to make our system more fragile not less (witness how concentrating risk in the mortgage market worked out). The expansion of deposit insurance will certainly reduce market discipline, all else equal, as will the labeling of certain entities as “systemically important”. And the new Consumer Financial Protection Bureau will make foreclosing on properties even harder next time, resulting in more delinquencies, rather than fewer. So yes the system prior to Dodd-Frank was badly broken, but Dodd-Frank, on net, has succeeded in making it worse.
Repeal, however, is not enough and not even the primary objective. That objective is a more robust financial system. Such would require greater capital, both on the part of financial institutions and borrowers. Also required is a reduction in our expansive bank safety net. Lowering deposit insurance to cover only middle class retail depositors; restricting the ability of the Fed, FDIC and Treasury to throw money at creditors; eliminating the tax preference for debt over equity; and reducing supply rigidities in our property markets. Other reforms are needed, but these would be important places to start.
Of course some or all of these could be done in addition to Dodd-Frank. I, however, believe they will not be. Dodd-Frank, for one, has managed to “suck up all the oxygen in the room” when it comes to financial reform, smothering discussions of alternatives. Almost every panel, debate or event on financial reform over the last five years has either been focused on or dominated by Dodd-Frank. Its certainly one of the reasons we haven’t seen reform of our mortgage financial system. Implementation of the qualified mortgage and qualified residential mortgage rules have actually delayed reform, as the exemption of Fannie Mae and Freddie Mac from those rules is about the only thing allowing our mortgage market to survive said rules.
Dodd-Frank’s approximately 400 required rule-makings results in our financial regulators having had almost no time to deal with issues unrelated to Dodd-Frank. The Act has placed blinders on our regulatory system. It has also driven partisan gridlock on Capitol Hill. I believe well intended members from both sides of the aisle want to address flaws in our financial system. Yet every attempt to legislate seems to break down along partisan lines and revert to slinging mud, rather than engaging in reasoned deliberation. The highly partisan manner in which Dodd-Frank was passed and has been implemented has left financial regulation more gridlocked than I’ve ever seen in my career. One would be hard pressed to design a more effective method to insulate the status quo.
Nor is simply accepting Dodd-Frank and moving on an option. The distortions noted above need to be addressed. In addition the substantial costs imposed on the financial sector will not just be accepted and adjusted to. Time and effort will be devoted to their modification or repeal. There is simply too much money at stake to expect otherwise. If we want to turn to the hard work of making our financial system safer, the first step in that journey has to be repealing Dodd-Frank.