Dodd-Frank Reform

Dodd-Frank reform seems to be back on the front burner, according to the latest Presidential executive order. At last.

But let us hope it can be done right. Simply pulling down regulations in ways demanded by big banks will lead, I am afraid, to lower capital standards, more debt implicitly guaranteed by the government, and just enough regulation to keep the big end of the banking industry protected from competition and disruptive innovation.

As with much reform, there is a rather detailed and clearheaded effort coming out of Congress, which gets much less attention than it should relative to the Administration's preliminary thoughts. Watch Rep Jeb Heainsarling's Choice Act for Dodd Frank reform. (Speaker Paul Ryan's "Better Way" plan is the one to watch on everything else. Though corporate taxes are getting a lot of news, the personal tax plan is more important.)

The core of the Choice act offers a clever carrot: Much less regulation in return for much more capital.

A reader asked me a while ago how I would deal with the extraordinary complexity of the Dodd-Frank act. I answered that fixing it was easy  -- a trained parrot could do it. Just teach the parrot to say "More capital. More Capital. More capital."  

Which is all to introduce a little essay I wrote that was serendipitously published last week in the Chicago Booth Review, "A way to fight bank runs—and regulatory complexity" It's a much edited version of an earlier blog post, and offers some suggestions on how even the Choice act might be improved. I'd copy it here, but the Booth Review team did such a nice job of formatting it that I'll hope to get you to click the link instead.

(I've been doing this for a while with the Chicago Booth Review, and they now have a page with all my essays.)


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The Wall Street Journal covers the issue well, in A Trump-Cohn Financial Rewrite,

Gary Cohn, who runs Mr. Trump’s National Economic Council, told the Journal that Dodd-Frank’s costs and complexity have restrained bank lending. 

True, but dangerous. I hear lots from the banker community that capital requirements restrain lending, which is not true. If the "costs" are costs of capital, we're in trouble.

The better way to prevent a panic is to have simple but firm rules along with high capital standards that make banks better able to endure losses in a downturn. That’s the philosophy behind House Financial Services Chairman Jeb Hensarling’s proposed financial reform, and it’s the direction the Trump Administration should take even without legislation.

But will it? The President signed his directives Friday after meeting with bank executives, and he didn’t help himself politically by praising the “great returns” BlackRock has earned. The point is to help the larger economy, not bank profits.

Especially not bank profits juiced by lots of leverage, which the government will bail out next time around, because "everybody knows" it was a huge mistake to let Lehman go under.

As a Goldman Sachs alum, Mr. Cohn has a particular burden not merely to relax regulations that are the bane of big banks while doing little to relieve the burden on their smaller competitors and tech start-ups. J.P. Morgan’s Jamie Dimon and Goldman Sachs’s Lloyd Blankfein have argued against a wholesale repeal of Dodd-Frank, which has given these large incumbents a competitive advantage.

As I warned above.

There is a huge difference between knowing how to run a bank -- Goldman Sachs, say -- and knowing how to run a banking system, or an economy.  Banks hate competition. Economies love it. We have seen this failure many times before when successful bankers or businesspeople move to government.  I hope Mr. Cohn can quickly put on a different set of goggles.

Although Mr. Cohn said the U.S. has the highest bank capital standards in the world, they aren’t as high as they should be. The trade he could offer Wall Street is less burdensome regulation in return for higher capital standards. The banks would then be freer to lend money while taxpayers have more protection against the next bailout. This would have the added political benefit of blunting the inevitable Democratic attacks that Messrs. Cohn and Trump are trying to help Wall Street.

And that is precisely the clever deal offered by the Choice plan.

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The Executive Order itself is interesting. (I'm trying to follow through on looking up primary sources, as I became aware in reading about corporate taxes just how much commentary spins on thin air.)

The key part is this

By the power vested in me as President by the Constitution and the laws of the United States of America, it is hereby ordered as follows: 

Section 1. Policy. It shall be the policy of my Administration to regulate the United States financial system in a manner consistent with the following principles of regulation, which shall be known as the Core Principles: 

(a) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth; 

(b) prevent taxpayer-funded bailouts; 

(c) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry; 

(d) enable American companies to be competitive with foreign firms in domestic and foreign markets; 

(e) advance American interests in international financial regulatory negotiations and meetings; 

(g) restore public accountability within Federal financial regulatory agencies and rationalize the Federal financial regulatory framework.  

I notice some key omissions. It does not say that the regulatory structure should be primarily aimed at eliminating financial crises or runs. It lists textbook "moral hazard and information asymmetry" so that's not just to avoid wonkish language.

That would have been helpful. Financial regulation combines (as usual) three goals: 1) stop runs and crises, which are fueled by short-term runnable debt, 2) consumer and investor "protection," an effort of debatable value though more important in an industry rendered less competitive by regulation, 3) transfer money and give cheap credit to political constituencies. Saying the primary goal is 1 would allow a big deregulation effort on 2 and 3.

"Moral hazard and information asymmetry" sound like textbook excuses for regulation. In fact most of the moral hazard and information asymmetry in financial markets are government failures, not market failures. Moral hazard results since the government guarantees bank debts, so banks have an incentive to take too much risk. Information asymmetry is forced by regulation such as rules that they can't use lots of available information in making loans. T

hese words apply to analyses of insurance markets, when customers may know more than insurers, and therefore markets break down. I'm scratching my head to think of widespread "moral hazard" and "information asymmetry" in unregulated bank operations. Are we really worried that people know more about their finances than banks can possibly know, given the ability to mine all your records with impunity (free market information asymmetry) so that nobody can get a loan because only the secret deadbeats apply? Just when did this start being the prime worry about unregulated financial markets? Just what are we talking about here?

Or is this a throwaway line that somebody lifted from an economics textbook so that it wouldn't sound like the Administration denies all regulation is bad? That impulse is good, but a better choice of words might have been wise in an executive order that will be cited for all kinds of both good and mischief.

It says "vibrant" but not "competitive" or "innovative," in the sense of new companies being able to offer new and better products to consumers. Foreign companies are great sources of innovation and competition! US cars are a lot better because of the pressure from Japanese imports, and French smartphones are a lot better because Apple is allowed to sell there. What's good for the goose is good for the gander. Competition in (d) and (e) sounds like pure mercantilism, and an inducement to lower, say, capital standards, and raise implicit guarantees, for existing big banks  to "compete," i.e. extract rents.

It also reads as if nobody had thought about fixing Dodd-Frank before. How about

"(f) Review existing analysis of the Dodd Frank Act, reform proposals, and legislation pending before Congress?" 

But all of this minor whining within the gray area. The refreshing part of the source document is that it is pretty vague, and if someone of my tastes -- or Rep. Hesarling's-- were implementing it, what we want to do could fit in well.  The dangerous part is that another reading is equally possible.