Dodd-Frank and the Status of Financial Regulation in Post-Crisis United States

WASHINGTON - JULY 21: U.S. President Barack Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act at the Ronald Reagan Building July 21, 2010 in Washington, DC. The bill is the strongest financial reform legislation since the Great Depression and also creates a consumer protection bureau that oversees banks on mortgage lending and credit card practices. Also pictured (L-R) are Vice President Joe Biden, Speaker of the House Nancy Pelosi (D-CA), Senate Majority Leader Harry Reid (D-NV), Rep. Maxine Waters (D-CA), Sen. Chris Dodd (D-CT) and Rep. Barney Frank (D-MA). Photo by OwenDB/Black Star***
Barack Obama, depicted, signed the Dodd-Frank Wall Street Reform and Consumer Protection Act at the Ronald Reagan Building on 21 July 2010. Since its passage five years ago, the results have ranged from “massive disappointment” to “complete disaster”.

When nations misdiagnose the causes of a particular problem, the proposed solutions often lead to negative unintended consequences. The most famous example of this is the Great Depression, when a series of government programs aimed at stimulating aggregate demand turned a sharp market correction into a 17-year downturn. One can fast forward 70 years to find the same trend presenting itself once again. Overregulation of the mortgage industry starting in 1992,  implementation of Basel II reserve ratio requirements in 2004, and expansionary monetary policy from the Federal Reserve starting in 2001 all joined to produce a housing bubble sized at $10 trillion that popped in 2008, causing a contraction in US GDP by 4.3%.

A pragmatic policy maker views these causes and seeks to mitigate them in the future.  The Consumer Protection and Regulatory Enhancement Act, introduced by Spencer Bachus III and sponsored by many Republicans, sought to change the role of the Federal Reserve to focus on price stability and revoke the federal charters of Fannie Mae and Freddie Mac, government-sponsored enterprises which underwrote many subprime mortgages to enforce the aforementioned federal regulations. The proposal rectified two of the three major issues that caused the housing bubble in the first place. Unfortunately, the bill did not pass, as left-wing politicians saw the crisis as an opportunity to consolidate power in government. They blamed the crisis on “reckless deregulation”, when the opposite actually occurred.

Two prominent Senators, Chris Dodd and Barney Frank, introduced the Dodd-Frank Wall Street Reform and Consumer Protection Act on 2 December 2009, which currently serves as the largest government intervention in the financial industry since the Banking Act of 1933. The law radically changed the regulations for financial institutions and derivatives trading. While Dodd-Frank was implemented to increase market stability and minimise systemic risk, the result has been the opposite.

The most noticeable rule in the juggernaut among consumers is known as the Durbin amendment, which places price controls on the fee that retailers pay when customers utilise a debit card. This has triggered a shift in the cost to maintain payment card systems from retailers to consumers. Before the law was passed, 76% of all banking accounts were eligible for complimentary checking. Due to the rule, only 38% qualified in 2014. The Durbin amendment has contributed to a growing crisis of unbanked populations in the United States, with an estimated 10 million households resorting to costly checking cashing and payday loan facilities.

One agency created by the law is the Financial Stability Oversight Council (FSOC), which claims to implement regulation to decrease systemic risk in the market. In the FSOC’s 2015 Annual Report, the majority of the major risks outlined are the result of either Dodd-Frank itself or misinformed government policy. The most prominent delineation is the lack of “housing finance reform”. In a case of disturbing cognitive dissonance, the FSOC praises Fannie Mae and Freddie Mac for again providing affordable housing, however it also harshly criticises an increased level of mortgage industry risk. At the very least, the report does finally admit that the liquidity support programs dispersed in the Emergency Economic Stabilisation Act of 2008 has led to a rise in moral hazard. Other than that isolated statement, however, the FSOC has only created another burden in the finance industry without providing any actual benefit.

Another mess is the regulatory environment governing systemically important financial institutions (SIFIs). If a firm is found to be integral to the function of the US financial system (“too-big-to-fail”), then the FSOC will implement capital, leverage, and liquidity requirements. While originally intended for banks, the scope of the regulations has already expanded to include AIG, GE Capital, and Prudential Financial. To make matters even worse, the Council is also considering the inclusion of mutual fund firms such as BlackRock, Fidelity and PIMCO. These burdens have greatly increased inefficiency to the point that MetLife, another firm awaiting SIFI designation, has filed several lawsuits and GE Capital is in the process of a spinoff to decrease inhibiting levels of overhead.

The most important rule, and perhaps the most infamous, is the Volcker rule, which places a ban on proprietary trading by financial institutions. The rule is not just misguided. It will serve as a catalyst for the next financial crisis. Bank analysts and even some regulators have become increasingly concerned with a lack of liquidity in fixed-income asset markets, particularly that of corporate bonds. This has already resulted in a surge in market volatility, demonstrated by the upward trend of the the VIX over the past several months. This instability can quickly place global markets in a quagmire when the current US equity bubble bursts.

As stated in previous posts, the next financial crisis should be an opportunity for sound regulatory reform, not a window of cheap political gain. When it hits, regulators will first blame financial markets and demand more control over them. Based on this current set of laws, the United States will need to learn its lesson, as it clearly failed to do so after the 2000s housing bubble. The push for government consolidation of markets must be resisted and replaced with a policy that promotes long-term economic stability.