Dodd-Frank
In a laissez-faire society, the government is supposed to take a hands-off approach to financial regulation (Geisst). However, a laissez-faire society would not work in the real world, so the questions are not whether there needs to be financial regulation, but how much of it is needed and where. Conservatives and Democrats naturally have conflicting views on financial regulation. Conservatives traditionally believe in having less regulation, while democrats believe in having more of it. These differing philosophies on financial regulation can be seen in the on-going debate over the Dodd-Frank Act with conservatives generally disagreeing with the act, and liberals generally agreeing with it. These two schools of financial regulation philosophy are prevalent in America’s history from the Great Depression to the debate over the Dodd-Frank Act.
In order to understand the risk of a loss of credit and systemic risk to the scale of the Great Recession, the Great Depression must first be understood. Part of the impetus for the Great Depression was the so-called “gold standard” kept by the Federal Reserve and many other central banks at the time, which caused deflation (Bernanke). The gold standard was kept by 59 nations around the time of the Great Depression, and studies have shown that the nations that stayed on it longer had a slower economic recovery (Ahamed 13 & Geisst). This deflation helped lead to the stock market crash that put an end to the 1920’s economic prosperity, lead to the depression, and prompted a banking crisis (Porter).
Part of the problem imposed by a banking crisis was a loss of credit, and because of the gold standard it was difficult for the Federal Reserve to encourage lending in order to maintain credit fluidity (Bernanke). Essentially, “the value of currency was tied…to a specific quantity of gold because the amount of currency that could be issued was tied to the quantity of gold reserves, [so] governments had to live within their means, and when strapped for cash, could not manipulate the value of the currency” (Ahamed 13). This practice made it difficult for the government to lend money and keep credit flowing in the market. The decrease in bank lending resulted in a loss of credit that created huge systemic risk within many financial institutions, which had a negative impact on America’s economy and the global economy to the point that some thought it was the “apocalypse” (Ahamed 4).
The similarities exhibited in many financial crises is perhaps best exhibited in the following passage in which the author is trying to put the Great Depression into the context of other financial crises.
“Financial crises would generally begin innocently enough with a surge of healthy optimism among investors. Over time…this optimism would transform itself into overconfidence…The accompanying boom would go on for much longer than anyone expected. Then would come a sudden shock…Whatever the event, it would provoke a sudden and dramatic shift in sentiment. Panic would ensue” (Ahamed 15).
The problem with such crises is that they often spread throughout the entire entire market “because financial institutions [are] so interconnected, borrowing large amounts of money from another” (Ahamed 15). This systemic risk in the banks during 1930 and 2008 affected virtually everybody in the United States including many different types of financial institutions and companies. In fact, in 1921, Montagu Norman, the governor of the Bank of England and one of the most influential central bankers in the world, said that the entire worldwide capitalist system was in danger of collapsing (Ahamed 5). In order to end the Great Depression, America’s president, F.D.R., ushered legislation through Congress called the National Industrial Recovery Act of 1933 (Geisst). This act was a part of the New Deal legislation, which created the basis for the modern regulatory state and greatly impacted the American financial system since it called for a large amount of new financial regulation (Porter). The New Deal included legislation that created the Federal Deposit Insurance Corporation, provided relief for the unemployed, and greatly increased the government’s regulation of all financial institutions.
In 2008, the United States faced another financial crisis that Montagu Norman, if he were alive at the time, might have said threatened the global capitalist system. This crisis is now commonly referred to as the “Great Recession”. The root cause of the Great Recession was subprime mortgages. Subprime mortgages are essentially loans that are granted to people who might have trouble repaying. Every bank and financial institution in the nation and worldwide was impacted directly or indirectly by this sub-prime mortgage crisis. Some of the largest companies in the world like the American International Group and many Wall Street investment banks were heavily invested in subprime mortgages.
During the early 2000s, consumers were building houses at a record rate, and banks were underwriting those mortgages at the same pace (Frank). Some banks made residential lending a major part of their business, meaning that many of their assets were actually toxic; they just did not know it at the time. The banks were bundling these mortgages and selling them off to investors, which tied in more people and companies to the dangerous investments (Wilmarth). Essentially, borrowers who could not afford to repay their mortgages received bank approval because banks were too eager to make a profit (Frank). The economy, meanwhile, started to contract sharply after 9/11. Borrowers were having difficulty repaying their loans because they were unemployed. There were few regulations at the time regarding debt-to-income ratio. Additionally, there was very little oversight on appraised values of homes. Eventually, subprime mortgages reached their tipping point, and they threatened to make some of the most powerful banks in America fail because these banks had invested too much of their capital into subprime mortgages, which quickly became toxic assets, a term coined after the 2008 recession meaning an asset that has significantly lost value and can no longer be sold, since it is guaranteed to lose money (Wilmarth).
Once the subprime mortgage crisis had reached its apex, many banks and other financial institutions were in danger of failing. The first major Wall Street bank to be in danger of failing was Lehman Brothers. The Federal government chose not to bail out Lehman Brothers because it thought Lehman Brothers did not pose a significant threat to the banking system, so Lehman Brothers filed for bankruptcy. The Federal government learned its lesson when it let Lehman Brothers fail because the Lehman Brother’s failure jeopardized many other banks since the banks were all interconnected (Levine). The government decided to bail out the other banks quickly after Lehman Brother’s failure through passing the Troubled Asset Relief Program (TARP) act in Congress. President Bush signed this bill into law in late 2008, hours after it had been passed in Congress. TARP was created to inject capital into banks to keep credit flowing. This was something the government did not do during the Great Depression because it was restricted from lending money to banks through the gold standard. The nine largest banks in America were required to take TARP; all other banks were given an option. This injection of capital into the economy was the government’s way of bailing the banks out, and it undoubtedly saved the global economy. TARP was the right thing to do since a central bank needs “to reestablish trust in banks” in the middle of a crisis, something that was not done in 1930 (Ahamed 15).
The Great Recession happened because of loose regulations for which the banking industry lobbied heavily. This lack of regulation not only allowed banks to underwrite riskier mortgages, but it also allowed banks to bundle and securitize these mortgages without much oversight. The government recognizes its failure and is trying to prevent it from happening again by “[calming] anxious investors and [soothing] skittish markets” (Ahamed 16). One way the government is attempting to prevent another similar crisis is through passing the Dodd-Frank Act, which is supposed to counter the lack of regulation that allowed the subprime mortgage crisis to happen. However, the new regulations might be too strict, which is hampering the economic recovery.
II Dodd-Frank Act Harm
The act’s primary purpose was to address the reasons for the crisis, yet it “is at best an incomplete vision” for preventing another subprime mortgage crisis (Chaffee 15). Not only does it fail to regulate the reasons for the crisis, but it also creates uncertainty in the financial markets because of the way its regulations will be implemented. Most of the regulation created by the act will come from regulating entities the act created (Weil, Gotshal, & Manges). Because many of these entities have either not been created, or they have not fully finalized their regulations, financial institutions do not know how they will be regulated (Weil, Gotshal, & Manges). Also, the act, when fully implemented, will make it harder for financial institutions to earn money because of excess regulation. In fact, some researchers have found that the Dodd-Frank Act made banks less sound because of its regulations (Calabria). Many are worried that the Dodd-Frank Act might “distort financial markets, limit access to capital, and increase costs for commercial end-users,” which would “put further strains on an already struggling economy” (Katz). However, this recommendation paper cannot focus on every aspect of the Dodd-Frank act because of its size. In order to be more detailed and specific, the following recommendations will focus on the Collins Amendment and the De Minimis Investment regulation. These two regulations focus on regulating the capital of banks. These regulations limit the freedom with which banks can use their capital to generate revenue, which hurts the economy.
III Policy Recommendation
The government needs to eliminate the harmful aspects of the act, such as capital requirements, because they will hamper America’s economic growth for years to come. Therefore, it is in America’s best interest for Congress to amend the Dodd-Frank Act and reduce its amount of regulation in the following ways.
First, simplify and reduce the capital requirements in order to make it easier for banks to manage their money. The capital requirements today dictate how a bank should manage its capital. There are other regulations that make it difficult for banks to earn money. All of these new regulations impact consumers. One of the arguments against these regulations is that banks will pass on some of the cost of these new regulations to customers.
An example of a capital regulation that should be amended is the De Minimis Investment regulation. The De Minimis Investment regulation deals with the causes of the Great Recession because it greatly reduces the amount of ownership a bank can have in an investment that it created. In the Great Recession, banks created funds that involved subprime mortgages and owned the majority of these funds. When the subprime mortgages lost their value, banks lost some of their capital. The De Minimis Investment regulation creates new regulations as to how banks can interact with the funds they organize and offer. According to the new regulations, a bank cannot sell shares of the fund to investors that are subsidiaries of the bank. The bank also cannot own more than three percent of the fund and put more than three percent of its tier one capital into these funds (Weil, Gotshal, & Manges). This regulation is beneficial to a point, since it prevents banks from investing in risky funds that it creates, but the regulation does not differentiate between sound and high-risk investments.
Furthermore, the De Minimis Investment regulation should be amended in order to distinguish between risky investments and sound investments by using credit ratings. Although these subprime mortgages were given a AAA credit rating, the way in which these credit ratings were applied was flawed. The government should create more regulations that are focused on the breakdown in how these ratings were applied in order to prevent something similar to this from happening again. The efficacy of the following policy recommendations is contingent on trusting the credit rating system to rate the quality of investments with more accuracy in the future.
It is recommended that the De Minimis Investment regulation be amended to stop regulations around bank’s involvement with the investments that it creates which have AAA credit ratings. Furthermore the De Minimis Investment regulation should be amended to allow banks to own up to 50% and put no more than 20% of its tier one capital in investments that it creates with some level of a AA credit rating; to allow banks to own up to 25% and put no more than 10% of its tier one capital into investments that it creates with have some level of a A credit rating; to allow banks own up to 10% of investments that it creates and put no more than 5% of its tier one capital into investments that it creates with some level of a BBB credit rating; and to not change the regulations for funds with some level of a BB credit rating or lower. It should be noted that these regulations are for investments that the bank creates and holds on its balance sheet. These regulations base the percentage of ownership banks are allowed to own in investments that they create on the rating of the investment. In order for these regulations to work, the credit rating system must work correctly so that banks cannot own too much of a risky investment that was given too high of a rating. Trusting the credit rating system is one of our only options if we want to increase our rate of economic growth more rapidly.
Second, amend the Collins Amendment. The Collins Amendment establishes a series of regulations on risk based capital that limit the amount of capital banks can put into into risky investments and hold on their balance sheets. Many of these requirements have not yet been finalized, but they will “raise the specter of additional capital requirements for activities that are determined to be risky” (Weil, Gotshal, & Manges). These activities include, but are not limited to, derivatives, securitized products, financial guarantees, securities borrowing, lending, and repos (Weil, Gotshal, and Manges). Regulating these aspects of the market, some of which have not had capital requirement regulations before, does make some sense, yet regulating aspects of the economy that have not been regulated before is a dangerous solution. It is important to keep these regulations manageable so that banks can still earn acceptable return. Otherwise, the banks will have less capital available to lend into the economy. It is recommended that these risky activities no longer be regulated forcibly, but with an incentive approach combined with manageable regulations in order to avoid harming the economy. This approach is advised because strictly regulating a bank’s capital just because of the risky investment activities it is involved with is not only unreasonable, but it can harm the economy and negatively impact the consumer.
Stringent and unnecessary regulations in the Dodd-Frank Act, like the De Minimis Investment regulation and the Collins Amendment, should be revised into more manageable and thoughtful regulations that will be simpler and less restrictive. The Collins Amendment should be replaced with some form of incentive regulation. This incentive regulation would not enforce the Collins Amendment, but rather provide benefits to those who do follow its regulations. Some possible benefits are providing tax deductions or granting federal money to the banks that meet the requirements. These incentives should be substantial enough to entice banks to handle their money according to the regulations, but not substantial enough to cost our nation over $1 billion dollars a year. The money for these incentives will come from the Department of the Treasury, and the budget they have already been given. The details of these incentives should be structured by experts in finance, banking, and economics because of their complex nature. One benefit of using incentive regulation in the Collins Amendment is that it is more politically plausible since the Collins Amendment could still be enforced. Another benefit is that banks would have a choice of whether or not to follow the regulations in the Collins Amendment instead of being forced to comply.
IV Conclusion
The Dodd-Frank Act was a response to a catastrophic crisis. However, in its attempt to prevent something similar from happening again, the act creates many unnecessary regulations. Among these are the capital oriented Collins Amendment and De Minimis Investment regulations. Additional amendments to the Dodd-Frank Act are needed to pass through Congress in order to implement the proposed changes. The benefit of these amendments, should they pass through Congress, is that banks will be able to generate more capital, which means that banks will lend more and help the economy. Another benefit of these amendments is that investments the bank creates that have a bad credit rating will be strictly regulated while investments the bank creates that have good credit ratings will not be as regulated so banks can generate more profits. Additionally, less federal money will be spent on regulating investments that a bank creates, and less corporate money will be spent on keeping up with the regulations because the regulations have been diminished and simplified. These amendments, if passed, will benefit consumers, the government, the economy, and banks alike.
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