The late Larry Ribstein explores the principles of a liberty-oriented securities regulatory regime.
Five years after its enactment, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 remains controversial. Critics argue that the statute imposes disproportionately large compliance costs on small community banks, institutionalizes “too big to fail,” and drives up the cost of banking services to consumers. Comparing Dodd-Frank to past securities reforms, particularly those of the New Deal, shows that these three problems are related and are nearly inevitable features of post-crisis legislation.
Every major financial reform in U.S. history was enacted in the aftermath of a substantial decline in equity prices. Each, in other words, was crafted during a time of public anger that politicians hoped to deflect from themselves to Wall Street. The congressional authors always compose a narrative of the stock market crash that blames unscrupulous financial intermediaries or public companies and insufficient regulation of the markets. Just as inevitably, proponents studiously avoid any suggestion that their own prior regulatory innovations had unintended consequences that contributed to the crash. Meanwhile, firms in the regulated industry concentrate on determining who the winners and losers may be under a new regulatory regime, so they can make sure they end up on the winning side.
This routine ensures that the primary losers from financial reform are investors and small, regulated firms. Costly new rules simultaneously serve the ends of Congress and the major financial institutions. They allow Congress to argue that it filled the regulatory gaps that it claims caused the crisis. Large firms can spread the new costs over a large number of transactions, giving them a structural advantage over their smaller and previously nimbler competitors. All firms will seek to pass on to their customers as many of the regulatory costs as possible.
All of this would be unfortunate but bearable if the new regulations generated benefits in excess of their costs. But that is unlikely with post-crisis legislation. The objective is to show the public that Congress is doing something and time is short. Congress knows relatively little about the details of market practices and so relies on the financial industry for information. The largest firms have skilled lobbyists and contacts with legislative staff. They argue, often successfully, that their ways of doing business are “best practices” and their competitors’ practices are shoddy or unfair. The process almost guarantees that the legislation will harm competition and therefore investors. Historically, that is precisely the pattern we observe, as demonstrated in my book Wasting a Crisis: Why Securities Regulation Fails.
The New Deal securities reforms, often seen as the classic example of good regulation, provide a cautionary tale. President Franklin Roosevelt and his administration argued that the 1920s were a time of widespread fraud and manipulation in the stock market, but there is scant factual basis for the claim. As my book demonstrates, the best-documented cases of “fraud” were no such thing; the evidence proves mostly that Congress did not understand how securities markets operate. By going back and analyzing market reactions to earnings announcements, I also show that the markets did not view the disclosures they received as a result of mandates from the Securities and Exchange Commission as more informative than the stock exchange-mandated disclosures of the pre-SEC era.
The 1920s were, on the other hand, a time of sharply increasing competition and innovation in the investment business. As a growing middle class looked for ways to invest its savings, a large industry of brokers, investment bankers, and investment managers developed to meet the demand. New entrants modernized the sales process, taking advantage of the rising number of households with telephones and radio sets. Like many creative new companies, they took business away from their more established competitors.
The New Deal reforms put the brakes on this innovation and competition. At the urging of the old-line investment banks, the securities laws defined the new sales practices as misleading and forced the industry to return to the traditional syndicated method of public offerings at which the established investment banks excelled. The securities laws comprehensively regulated brokers, stock exchanges, and listed companies, subjecting small, regional businesses to costs they could not bear.
The results were dramatic:
- Industry concentration increased promptly and measurably. By my estimate, the New Deal securities laws increased the aggregate market share of the top five investment banks by 12 percent.
- Smaller securities dealers based outside New York City began to exit the business despite having survived the worst phase of the Great Depression.
- Regional stock exchanges began a terminal decline. Of the 41 exchanges in existence when the Securities Exchange Act went into effect in 1935, only 20 survived until 1938, despite the fact that many of them had survived the financial panic of 1907 and the recession of 1920-21.
- Regulators helped enforce anticompetitive practices such as fixed brokerage commissions that increased investors’ costs.
Dodd-Frank, for its part, has a broader focus than the New Deal securities laws. It changes the regulatory framework for the entire financial system, including commercial banks, investment banks, investment managers, and insurance companies. Its counterproductive effects are therefore potentially even more far-reaching and costly to consumers. At the most basic level, it gives the federal banking regulators the authority to identify “systemically important” financial institutions. These are pre-cleared for a bailout during the next financial crisis. In return, they become in effect wards of the state, with regulators having broad discretion to oversee their business practices.
Dodd-Frank also requires major changes to the over-the-counter derivatives market. Lawmakers argued that “opaque” and “risky” derivatives contributed substantially to the financial crisis. This is true only in the sense that anything that reduces the transaction costs of borrowing leads to more borrowing. The financial crisis was fundamentally a problem of financial institutions taking highly leveraged positions in mortgage-related assets. Derivatives are only one of many vehicles by which they did so. Leverage is the problem, not the specific contracts by which it is achieved.
Congress therefore devised a solution to a non-problem by requiring that many over-the-counter derivatives be centrally cleared, meaning there must be an institution (typically owned by other financial institutions) that guarantees each party’s performance to the other. These central clearinghouses are eligible for “systemically important” status and will be in line for bailouts during the next financial crisis as well.
There are plausible arguments that the 2007-2008 financial crisis was exacerbated by the unintended consequences of governmental policies, including interest-rate decisions by the Federal Reserve, housing policies administered by banking regulators, politically-driven risk weights within the risk-based system of capital requirements, and the tendency to bail out large institutions in financial distress. Dodd-Frank increases the likelihood that regulators’ missteps will be a significant contributor to the next financial crisis. But because governmental actors strongly resist admitting mistakes, it, too, will be blamed on “reckless” bankers, clearinghouses, insurance companies, or other financial intermediaries.
And then the cycle will start again, with more regulations that will cause more unintended consequences for which Wall Street will be blamed.