Regulatory Decadence and Dodd-Frank


Enacted swiftly in the wake of the financial crisis, the 2,319 pages of the Dodd-Frank Financial Reform legislation contain a thicket of rules overhauling the entire American financial system, creating a bevy of new regulatory entities.  But that is only the tip of the iceberg—for even then, this does not include the thousands of rule-makings, studies, and enforcement actions that will be triggered by Dodd-Frank, nor does it consider all of the international implications of the legislation.

Those looking for a roadmap that lays out the basic ideas that animate Dodd-Frank and its key provisions should turn to David Skeel’s book, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences.  Skeel summarizes Dodd-Frank in 200 readable pages that leads the reader through the basic provisions of the historic legislation and its consequences, both intended and unintended.

During the final debates over the passage of Dodd-Frank, Texas Republican Congressman Jeb Hensarling observed that “There are at least three unintended consequences on every page of this legislation.”  Quite a few for a bill that ran to 2,319 pages.  Skeel picks up on this theme and after starting by explaining the intended goals of Dodd-Frank and the ways in which the legislation attempts to implement them, concludes that in fact Dodd-Frank will have negative unintended consequences that will vastly exceed the beneficial intended effects of the legislation.

Skeel observes that “Contrary to rumors that the Dodd-Frank Act is an incoherent mess… [it] has two very clear objectives.” (p. 4)  First, Dodd-Frank seeks to reduce the risk of the financial system before the fact by regulating the “shadow banking system,” especially derivatives, which traditionally have been largely unregulated and governed by rules of private contract, rather than traded on exchanges and heavily regulated.  The legislation also adopts a variety of mechanisms designed to reduce the risk of financial failure of these institutions in the first place through its new rules supervising the activities of these large financial institutions.  He deems the first group of rules (i.e, regulation of derivatives) as the regulation of the “instruments” of the financial world and the second (regulation of large banks) the regulation of the “institutions” of the financial world.

Second, Dodd-Frank seeks to limit the damage after the fact caused to the financial system by the failure of a large, interconnected, so-called “systemically risk” or “too-big-to-fail” institution in order to avoid the perceived Hobson’s choice of modern regulators: on the one hand to bail-out large financial institutions or on the other to allow them to fail and potentially create a contagion effect that will damage the entire financial industry, by creating a new regulatory procedural mechanism for resolving the financial distress of those institutions.  Skeel argues that most of the provisions of Dodd-Frank can be seen as being animated by the pursuit of one or both of these objectives.

Having credited the drafters of Dodd-Frank with articulating coherent and reasonable goals, however, Skeel is withering in his assessment that the legislation itself will likely be a complete failure in attaining its intended objectives.  In fact, not only does Skeel conclude that Dodd-Frank will largely fail in accomplishing its central objectives, it will create additional unintended consequences that will result in substantial economic, financial, and even political harm.

The core of Skeel’s argument is that far from attenuating the worst excesses of the ad hoc bailout government interventions taken in response to the financial crisis, Dodd-Frank “could permanently ensconce the worst tendencies of the regulatory interventions during the recent crisis as long-term regulatory policy.” (p. 8).  Thus, Skeel observes “The problem isn’t with Dodd-Frank’s two main objectives.  The objectives are right on target.  The problem is with how they are handled.”  And why is that?  “The two themes that emerge, repeatedly and unmistakably, from the 2,000 pages of legislation are (1) government partnership with the largest financial institutions and (2) ad hoc interventionism by regulators rather than a more predictable, rules-based response to crisis.  Each could dangerously distort American finance, making it more politically charged, less vibrant, and further removed from basic rule-of-law principles than ever before in modern American financial history.” (p. 8).

Skeel argues that these tendencies manifest themselves in a variety of ways in the legislation.  He usefully distinguishes between two different regulatory approaches that Washington could have taken in response to regulatory reform: a “corporatist” approach or what he deems a “Brandeisian” approach, after Louis Brandeis the populist reformer whose ideas animated many of the reforms of the New Deal banking system.  The “corporatist” approach is one in which government and the financial system are essentially interlocked in a symbiotic relationship and the government singles out the largest institutions for special regulatory treatment, making them functionally public utilities.  The “Brandeisian” approach, by contrast, is more populist—rather than seeking to regulate and limit the systemic risks associated with large financial institutions, for example, a Brandeisian approach would seek to eliminate systemic risk by breaking up supposedly too-big-to-fail institutions into smaller institutions that would not raise the same risks.

Skeel notes that except for a few very specific instances Dodd-Frank adopts the corporatist approach.  In large part he attributes this approach to the unique biases of the main characters involved in shaping Dodd-Frank—most notably Timothy Geithner, but also Hank Paulson, Ben Bernanke, and even President Obama.  Skeel argues that Geithner’s worldview was shaped by two pivotal events earlier in his career, the U.S. government’s response to the 1994-95 Mexican currency crisis and the government’s engineering of the bailout of Long-Term Capital Management in 1998.  Skeel argues that the lesson that Geithner learned was that “bailouts are the best response when a large institution or country is in trouble,” (p. 45) a mindset that pervaded his response to the financial crisis as well as the structuring of Dodd-Frank.

Skeel also points to a second factor that shaped the narrative of Dodd-Frank in a corporatist direction: the “myth of Lehman Brothers” and the lessons of the Chrysler and GM bailout-bankruptcies.  With respect to Lehman, Skeel argues that the government (and others) believed that they learned two lessons: first, the specific claim that bankruptcy was inadequate to deal with the resolution of a large financial firm; but second, that government discretion could not be bound by a rule-based system such as bankruptcy law.  Skeel spiritedly criticizes both of these assumptions.  The lessons of the automaker bankruptcies, however, were even more pernicious: in Chrysler and GM, the government committed rampant violations of the rule of law, shredding established bankruptcy procedures and policies in order to redistribute wealth from property owners to politically powerful interest groups (namely the United Auto Workers) as well as using its power to force private businesses to advance other government policies, most notably through provisions in the Chrysler bankruptcy that increased Fiat’s ownership stake in the company provided it met certain targets for the manufacture of energy-efficient cars.  After the acceptance of the Lehman myth, purportedly too-big-to-fail entities such as AIG and large banks could hold the government hostage and force a bailout; the automakers suggested that in exchange for the government’s role in propping up politically-connected firms the government could use its influence to force those entities to advance the government’s political interests.

Skeel notes that this overall corporatist structure likely will prove very dangerous in practice.  By solidifying the “special” status of the largest banks Dodd-Frank has entrenched and expanded the “Fannie Mae” effect—the implicit government guarantee for these institutions will allow creditors to lend to them with lower risk, thereby reducing the cost of acquiring capital for these institutions.  In turn, this cost advantage will enable them to out-compete their smaller rivals, promoting a consolidation of the banking industry—making them still-larger and more important.  Moreover, when combined with Dodd-Frank’s general thrust of entrenching regulatory discretion it will increase the influence of backroom dealing between these banks and their regulators, enabling them to evade many of Dodd-Frank’s regulations.  In turn, this heightened discretion provides a vehicle for the government to use its regulatory power to extract political promises out of these banks, using the Chrysler case as a prototype.  Moreover, Skeel notes that Dodd-Frank transfers huge amounts of power from bipartisan regulatory agencies (such as the SEC and Federal Reserve) to the Secretary of Treasury, putting these decisions much closer to the vortex of political power.  The end result will likely be crony capitalism at its worst, as the government props up and subsidizes the largest banks while at the same time using them to pursue its political purposes outside of the democratic process.

Skeel’s book is a crucially important contribution to understanding Dodd-Frank.  Indeed, many of Skeel’s criticisms echo those that I have made (see here, here, and here).  After the burst of ad hoc, politically-motivated interventions that shredded the rule of law, Dodd-Frank does not put the genie of government discretion back into the bottle, but instead entrenches it in the guise of legislation.  But while giving the appearance of imposing new rules, Dodd-Frank actually merely codifies this discretion and in many instances substantially enlarges it.  It specifically grants huge discretionary powers to regulators (such as the breathtaking powers to “resolve” the failure of large financial institutions with minimal notice and due process and virtually no judicial review) it also contains hundreds of rule-making proceedings with no legislative oversight.  Politicians will always favor enlarged discretion as a means to increase their power and the opportunity to bargain with powerful interest groups and large, politically-connected interest groups favor discretion for similar reasons.  It is only constitutional government and the rule of law that protects ordinary citizens who cannot hire the lawyers and lobbyists to manipulate the levers of power effectively.

I have argued that such is the case with government response to a crisis—once government slips its constitutional reins it is rarely the case that subsequent activity puts government discretion back under the rule of law.  Such was the case with the government’s interventions during the New Deal and that lesson has been relearned from the financial crisis.  The only way to prevent this ratchet effect from occurring is to tie the government’s hands in the first place preventing it from taking actions that violate the rule of law.  Politicians face overwhelming incentives to bail out failing firms: while there are risks of allowing firms to fail most of the costs of bailouts are borne in the future through the moral hazard that is created by bailouts.  But in addition this moral hazard creates its own bailout dynamic: firms then have an incentive to force the government’s hand into a bailout, as was the case in Lehman Brothers and General Motors, in which the companies ostentatiously took no precautions to prepare a chapter 11 filing, thereby virtually guaranteeing that any bankruptcy would be as catastrophic as possible.  In turn, this “messy” bankruptcy is exactly what the government feared, thereby forcing a bailout.  Thus, as Skeel notes, Lehman Brothers had ample opportunities in the days leading up to its bankruptcy for private transactions that would have saved it, but tried to hold out for a better deal in the belief that the government would bail it out (as had been done with Bear Stearns a few months earlier).  Moreover, Skeel shows that the market itself believed that Lehman would be bailed out, as reflected in the absence of any risk premium for Lehman in the days preceding its failure.

The only truly problematic chapter in the book is the one addressing the creation of the Consumer Financial Protection Bureau.  Skeel sees the creation of the CFPB, along with the Volcker Rule which prohibits “proprietary trading” by banks, as the only major instances of the triumph of the Brandeisian view of reform over the corporatist.  Even then he contends that the Volcker Rule will turn out to be less-restrictive in practice than expected because of the regulatory discretion involved with defining “proprietary trading” and the threat of affected institutions to take their operations overseas in order to evade it.  But Skeel contends that the creation of the CFPB was an unadulterated political loss for the big banks and a great populist Brandeisian victory for consumers and its sponsor, then-Professor, now-Senator-elect, Elizabeth Warren.

With respect to the CFPB, however, Skeel inexplicably forgets his own well-placed skeptical instincts.  Indeed, large banks early on accommodated themselves to the creation of the new bureau and to date its loudest critics have been smaller community banks and credit unions.  Skeel’s assumption that the creation of the CFPB was a major loss for big banks but not smaller banks rests on his interpretation of one particular provision of Dodd-Frank (Section 1026) that gives the CFPB exclusive jurisdiction over large banks and, he claims, “much less authority with smaller banks.” (pp. 107-08).  But Skeel’s interpretation of Section 1026 overstates the restraints on the CFPB’s powers with respect to smaller banks (under $10 billion in assets in this case).  Although that provision exempts smaller banks from direct examination by CFPB, the Bureau can demand reports from smaller banks and can report suspected violations to the Fed for action, to which the Fed must respond within 60 days.  Most important, any rules written by the CFPB to implement statutes such as the Truth in Lending Act apply with equal force to all banks, big and small.  Because the costs of regulation, is often not proportional to size, meaning that regulatory costs often fall heavier on smaller firms than larger.  Community banks have argued that is exactly the effect of Dodd-Frank and the CFPB’s rulemaking.  Moreover, the broad, vaguely-defined powers of the CFPB and its lack of transparency and legislative oversight provide exactly the same sort of room for political bargaining that Skeel details for the other aspects of Dodd-Frank.  The unequal regulatory burden imposed by CFPB on smaller banks will further exacerbate Dodd-Frank’s tendency to promote consolidation of the banking industry.

The one final rulemaking issued by the CFPB, which addresses foreign remittances, illustrates the point.  As initially issued, the rule would have required extensive disclosure of all the costs associated with conducting a financial remittance—including any costs charged by the firm receiving the remittance.  That is fine for a huge, multinational bank, which can simply send these transfers to one of its branches in Mexico City or Bogota or which makes thousands of such transfers to various cities around the world every month.  But what of a small community bank that knows little about the operations of the recipient of its transfers and makes only a few dozen such transfer per year?  While a nifty idea in practice, making American banks responsible for compiling a detailed list of the fees charged by foreign institutions is unworkable and unduly expensive.  As a result, many smaller banks have announced that they will simply exit the market rather than trying to bear the regulatory cost and headaches.  Indeed, so misguided was the initial set of CFPB rules that the Bureau has been forced to backpedal on some of its more onerous provisions and to delay its effective date.  Community banks have also complained about the costs imposed by the Bureau’s proposed mortgage disclosure rules, which if implemented will drive many community banks out of the home mortgage business, further increasing the market power of the largest banks.

A variety of other provisions of Dodd-Frank, as implemented by CFPB, will also tend to expand the footprint of larger institutions as the expense of community banks.  In particular, smaller banks compete on the basis of close relationships with their customers and the ability to draw on “local knowledge” (in Hayekian terms) and long-standing relationships that enable them to tailor lending products to the peculiarities of particular customers.  Because of Elizabeth Warren’s misplaced obsession with “simplicity” of lending products as an end in itself, however, the CFPB will be oriented toward cookie-cutter rules that create commodity-style loan products, eliminating the comparative advantage of smaller institutions for superior customer service and further accelerating the dominance of low-cost providers.  The initial proposal for preferred standardized “plain vanilla” products, of course, would have had exactly that effect, and forthcoming rules on matters such as “qualified mortgages” and eventually credit cards will likely have a similar effect.  Because larger institutions benefit when products become more standardized and underwriting more mechanized, all of these regulatory innovations will tend to promote further consolidation of the market.  Indeed, the continued uncertainty about the scope and risk of the qualified mortgage rule had led many smaller institutions to exit or significantly curtail their mortgage lending operations—leading to further consolidation in the hands of large lenders.

A further example is the virtual war on mortgage brokers launched by Dodd-Frank.  It is undoubtedly true that mortgage brokers helped to light the tinder that eventually led to the housing crisis through low-down payment mortgages and the like.  But as economic analysis has shown, mortgage brokers can also be an important positive competitive check on depository institutions, leading to lower prices and higher-quality service for consumers.  Overly-rigid restrictions on mortgage brokers, therefore, will further consolidate the mortgage market in the hands of large banks.  Thus while Skeel singles out the elimination of the so-called yield-spread premium for mortgage brokers as a positive impact of Dodd-Frank, neither he nor the CFPB itself has expressed an awareness of the potential for Dodd-Frank to have the unintended consequence of driving mortgage brokers out of the market and consolidating the market for big banks.

But any criticisms of Skeel’s book are really limited to this one chapter—and ironically, the basis of my criticism is that he has failed to apply the same jaundiced eye to the CFPB as he did to the other elements of Dodd-Frank.  Skeel predicts that Dodd-Frank’s unintended consequences will swamp any beneficial consequences that the legislation may have.  On that point his predictions are spot on.  And for that reason, while numerous books will be written on Dodd-Frank, Skeel’s book will provide the starting point for discussions about Dodd-Frank’s likely effects—and eventually the reforms that will be necessary to salvage it.

Todd Zywicki

Todd J. Zywicki is George Mason University Foundation Professor of Law at George Mason University School of Law and Senior Fellow of the Mercatus Center. He is the co-author of “Consumer Credit and the American Economy” with Thomas A. Durkin, Gregory Elliehausen, and Michael E. Staten (Oxford University Press, 2014).

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