Why Dodd-Frank Is Already Failing

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.

Reader Discussion

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on September 18, 2015 at 17:42:15 pm

I'm not sure I understand the system the author thinks will benefit investors.

Is the idea that financial institutions should be unregulated and when they become insolvent, the Federal government liquidates them under the bankruptcy system called for in the Constitution, and that will somehow benefit the investors??

Is the idea that the investors in Lehman, Bear, AIG, GM would have been made whole if those firms had been forced into bankruptcy and debts defaulted on, and the firms liquidated by a bankruptcy judge and the security holders of the debt would have gotten all their money back, the shareholders would have seen their share return to 2007 values?

I have spent my adult life watching the constant deregulation of finance to spur innovation to make credit easier with less paperwork, and the elimination of all requirements I grew up with: income and assets in excess of the demands of the debt. I grew up learning from my parents and society to rid one's self of debt, to "burn the mortgage" by paying it off early. But post Reagan taking office, everyone started telling to borrow more money, telling me that I could borrow against my house and go on cruises, borrow even more on my house and speculate on stocks. Plus I got two or three "you have a credit card with $5000 credit already approved if you just sign this" every week.

Before Reagan, I was told that merely having a job for three years and $2000 in the bank was not sufficient to pay to get an Amex card for international travel that would cost $1000 max. After Reagan, inflation had turned that $1000 into maybe $3000, but now I was good for tens of thousands in credit merely because I have a mortgage that was sized for a mansion before Reagan.

You seem to be obsessed with the costs of financial transactions reducing asset churn in going deep in debt, blaming only high leverage. But the inhibitor to debt these days is preventing high leverage - the only thing needed to borrow is proving the leverage is very low and ability to repay high, but that makes the debt virtually risk free and risk free debt carries the lowest interest rates, and is the debt most likely to be paid off quickly. The standards are still easier than they were in the 70s when I could not get modest credit even with lots of assets and income to back it.

And my personal experience with Wall Street is that even my suspicion they are crooks and liars is insufficient to prevent me from being swindled thanks to just the deregulation in the 80s. You might call that innovation, but I call it theft by deception, except it was made legal in most cases. A $10,000 lesson teaching "innovation means rentier capitalism that will take all your hard labor savings".

After all, those who call for letting the free market and bankruptcy courts handle everything are simply arguing that everything becomes wards of the state when the innovation fever captures the economy - bankruptcy is government redistribution of wealth from the savers to the reckless wreckers.

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on September 21, 2015 at 09:01:30 am

All of your complaints about the evolution of the banking systems have been clearly traced to the impact of governmental regulation of and intervention in that system.

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