Recommended Reading on Dodd-Frank and its Aftermath

By at 31 March, 2017, 3:32 pm

(and why we need to clean up the mess)

First in a Two-Part Series

by Raymond J. Keating-

It’s not unusual for politicians to react to a real or perceived crisis by haphazardly doing “something.” We saw this during the debate over ObamaCare. That is, our health care system was declared a mess (despite it being one of the most advanced on the planet, though not without problems), and ObamaCare advocates proclaimed that “something” had to be done. And as we see time and again, the government “solution” often winds up worse than the original problem.

A similar scenario played out following the credit and economic mess of 2008-09, which led politicians to rush in, with Congress passing and President Obama signing into law the Dodd-Frank financial regulatory bill. The Dodd-Frank law is a massive regulatory undertaking that’s still being sorted out nearly seven years later, while reforms or outright repeal are being considered.

As the Dodd-Frank debate heats up once again, it pays to take a moment, and get a refresher on what this law is about, how it grew out of mistaken assumptions, where it went badly wrong, and what’s needed in terms of reform. Fortunately, the Mercatus Institute at George Mason University recently published a report by Hester Peirce titled Revisiting Dodd-Frank that ranks as recommended reading, including for small business owners who have been affected by Dodd-Frank’s negative effects on lending.

For our purposes, I’m going to highlight 8 points here served up by this Dodd-Frank primer:

1. Regulatory Failure Leads to More Regulatory Control and Threat of More Regulatory Failure?

The overarching problem with Dodd-Frank is summed up this way: “Rather than addressing the regulatory failures that led to the crisis, Dodd-Frank’s core solution was to shift decision-making from the private sector to regulators—the same regulators whose lapses had contributed to the crisis. Dodd-Frank has been costly in the short term, as any major regulatory overhaul would be. The financial industry and regulators have poured countless hours and dollars into implementing the new law. Of greater concern than these short-term implementation costs are Dodd-Frank’s potential long-run costs. Rather than averting crises, Dodd-Frank’s rejiggering of the financial system has created the preconditions for a future crisis, while inhibiting economic growth and dynamism.”

2. Misguided, Dangerous Faith in Regulation

Dodd-Frank places too much faith in the power of regulators: “Dodd-Frank is a sprawling law, many pieces of which are unrelated to any financial crisis—past or future. What unifies the disparate pieces is an unquestioning faith in regulatory omniscience and broad grants of power to these infallible regulators. The law calls on regulators to step in where the rest of us—individuals, firms, and nongovernmental institutions—are supposedly destined to fail, namely, to identify and address all systemic and a wide array of nonsystemic risks… Financial regulators thus become central planners charged with carefully balancing the interests and risk-taking of all market participants, ensuring that firms do not fail, keeping the financial system functioning smoothly, and managing firms’ relationships with one another. This form of regulation turns regulators into allocators of credit: regulators decide who gets financed and who does not, which, in turn, affects how the economy develops, which consumer and business needs are met, and where innovation occurs.”

3. Missing the Real Causes of the Financial Crisis

Congress and President Obama failed to understand, or chose to ignore, the actual causes of the financial crisis, resulting in a massive regulatory scheme that has little or nothing to do with addressing actual causes. For example, “research has shown that regulatory errors lay at the heart of the crisis. Regulatory decisions drove firms and individuals to make poor choices that they otherwise would not have made. For example, Stephen Matteo Miller has demonstrated that regulation created a demand by financial institutions for mortgage-related, structured products by classifying them as safer than the underlying mortgages. Arnold Kling and Russell Roberts likewise point to the government’s inadvertent contributions to the financial crisis through misguided regulatory and housing policies. Lawrence White has highlighted the role that credit rating agency regulation—which forced firms to rely on government-credentialed credit rating agencies and kept competitors out—played in the crisis.” These problems are not redressed via Dodd-Frank.

4. Rein in Regulatory Control

This overview of Dodd-Frank, of course, is undertaken to offer recommendations for fixing what’s wrong with the law. Peirce, for example, writes: “Title I is devoted to systemic risk. Its key features include the establishment of the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR) and the introduction of formalized systemic risk identification and regulation… [The FSOC] could be retained to facilitate inter-agency discussions, assessments of the financial system, and analyses of the costs and benefits of multiagency regulatory initiatives. Even if the FSOC is retained for these purposes, the FSOC’s other functions—identifying systemically important institutions and activities and recommending courses of action for other regulators—should be eliminated to avoid distracting from and hindering the FSOC’s role in fostering regulatory cooperation and information sharing.”

5. Really End “Too Big To Fail”

A political selling point on Dodd-Frank was that it would end “too big to fail,” that is, end taxpayer bailouts of big financial institutions. Unfortunately, it actually places a process for such bailouts into law: “For financial firms that regulators deem too big to fail, Title II of Dodd- Frank allows regulators to bypass bankruptcy in favor of a resolution process run by the Federal Deposit Insurance Corporation (FDIC). Specifically, Title II empowers the FDIC, after a government finding that default is on the horizon and there is ‘no viable private sector alternative,’ to take over nonbank financial institutions (an area in which the FDIC lacks any particular expertise) and allows the agency to borrow from the Treasury to fund the resolution… A better approach would be to amend the bankruptcy code to make it workable for large financial companies.”

6. Less Capital Available for Entrepreneurs

Dodd-Frank effectively reduced the number of investors able to invest in entrepreneurial firms. Peirce notes: “Title IV tightened the accredited investor definition, which determines who can invest in certain nonpublic securities offerings, by excluding investors’ primary residences. Narrowing the universe of accredited investors harms the economy and investors by artificially constraining the flow of capital and investors’ options. To foster economic growth and investor autonomy, reform instead should allow more investors to qualify as accredited.”

7. Weakening Banks

Dodd-Frank actually weakens the financial strength and stability of banks: “Title VI of Dodd-Frank expands the Fed’s powers to regulate systemic risk associated with large financial institutions and introduces the so-called Volcker Rule to ban banks from proprietary trading and private fund ownership… The Volcker Rule could make financial institutions less stable. Although the intention of the Volcker Rule—stopping banks from trading with deposit insurance backing—is commendable, there are better ways to address this problem, including requiring banks to be well capitalized. Forcing banks to forgo the benefits of diversification by narrowing the activities in which they are engaged may actually weaken the banks and make them more vulnerable to risk.”

8. Lack of New Entry and Innovation

Peirce points out problems with Dodd-Frank limiting innovation and the entry of new banks. This phenomenon not only negatively affects low- and moderate-income earners, but also small businesses seeking financial capital. Peirce points out: “Title XII seeks to increase ‘access to mainstream financial institutions,’ but it does this by subsidizing bank lending to low- and moderate-income individuals. A preferable approach would be to expand unsubsidized private lending by lowering regulatory and litigation obstacles. Eliminating or reforming the CFPB, which—along with other legal and regulatory developments—has heightened the legal risk of engaging with low- and moderate-income customers (or at least restructuring it to facilitate accountability), would help. Also helpful in this regard would be a mandate to regulators to provide the flexibility necessary to accommodate innovation in the customer financial services space, rather than using rules and enforcement actions as a signal to would-be innovators that serving low- and moderate-income consumers carries with it heightened legal liability. Lowering regulatory barriers to entry and reducing the regulatory privileges enjoyed by incumbent financial institutions are two ways to invite innovators to offer consumer financial services to underserved populations.”

There’s more to be read and digested in Revisiting Dodd-Frank, and I, again, recommend it to the reader. Looking ahead, in the second part of this series, we’ll take a look at some measures in Congress that begin to deal with the varied ills of this regulatory monstrosity.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.

Keating’s latest book published by SBE Council is titled Unleashing Small Business Through IP:  The Role of Intellectual Property in Driving Entrepreneurship, Innovation and Investment and it is available free on SBE Council’s website here.


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