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Four years later, Dodd-Frank fails to turn banks into pet shops

July 25, 2014, 6:09 PM UTC
Image #: 29686294 LIMPOPO, SOUTH AFRICA - UNDATED: A caracal kitten at Loebies Guesthouse and Predator Park in Limpopo, South Africa. A BABY lion cub growls with joy as he explores his new surroundings. The cute youngster is the latest house guest of Annel Snyman, owner of Loebies Guesthouse and Predator Park in the Limpopo province of South Africa. At present the 32-year-old is required to play mum to cub Robyn, who has to be bottle-fed and winded. Loebies is home to lions, leopards, caracal, servals, as well as the 32-year-old's faithful dog Diesel and a mob of meerkats. The South African has been hand-rearing wild animals since 2009, and says the big cats have become an essential part of her life. And while nursing a lion might not be for everybody, Annel has no doubt that she has found her calling. Annel Snyman/Barcroft Media /Landov
ANNEL SNYMAN Barcroft Media /Landov

This week marked another anniversary for Dodd-Frank, the banking reform law that was passed in the wake of the financial crisis.

And it wasn’t even a big one. Dodd-Frank turned four. And yet lots of people wanted to talk about it. Because, I guess, who doesn’t long for an opportunity to talk about banking reform? The Congress even hauled Barney Frank out of retirement to talk about it. Clearly, next year’s Dodd-Frank anniversary party is going to be epic.

Sadly for the law, much of what people had to say about Dodd-Frank on its birthday was downright mean.

The Wall Street Journal published an editorial by Peter Wallison of The American Enterprise Institute titled “Four years of Dodd-Frank Damage.” Wallison said the “pernicious” effects that the banking reform law has had on our economy and society prove that critics of Dodd-Frank were “if anything, too kind.”

But one of the oddest, and surprising, attacks on the law this week came from a paper by two economists, Sohhyun Chung and Jussi Keppo, with an assist from WSJ. The paper found that the Volcker Rule, the part of Dodd-Frank that bans a lot of risky trading at the big banks, has actually made banks more likely to fail and less valuable.

How, you might ask? The paper argues that when you prevent banks from making risky bets with their own money, they won’t stop betting. They’re banks, after all. Instead, they will put more of their money into stuff that is less risky. And they will lend more, which is also risky, but allowed by Dodd-Frank. Also, the banks will pay dividends, which doesn’t sound risky. But if you allow banks to use their capital to pay dividends, they won’t have as much money around to cover loans when they go bad.

Journal reporter John Carney chimed in that, as the paper predicts, banks are holding more Treasury bonds, up 23% in the first quarter of 2014, than before the Volcker Rule was finalized last year. The Volcker Rule, Carney wrote, has sprung a leak.

More evidence that the Volcker Rule isn’t working: JPMorgan Chase’s second quarter. The nation’s largest bank’s value-at-risk was up by 22% from a year ago. And remember, the second quarter was at a time when volatility and risk seemed to be plunging on Wall Street.

But JPMorgan (JPM) doesn’t seem to be loading up on Treasury bonds or other investments that may be risky but are still allowed by Volcker. Its Treasury bond holdings, for instance, are down 28% in the past year. So, if JPMorgan’s risk is up, it’s because it is trading more risky stuff, not because of a loophole in the Volcker Rule.

In fact, much of the jump in Treasuries in the first quarter came from Bank of America (BAC), which upped its U.S. government bond holdings by $20 billion in the first quarter. But the bank still holds about half as many Treasury bonds as it did two years ago.

The major jumps and dips in Treasuries at the big banks suggest that these firms are trading them more. And that might not be great. By devoting more of their money to less risky assets, banks could end up losing just as much. Volcker does not appear to have stopped trading at the banks; in fact, many big banks have devoted more assets to trading than they had before the rule was put into place.

But if banks are going to trade, why not Treasury bonds? Such assets, after all, are sometimes labeled risk-free. The thing is, they are not risk-free. At the same time, Treasuries are a lot less risky than putting your money, or your depositors’ money, in CDOs of mortgage bonds.

The Volcker Rule doesn’t seem to have stopped banks from lending. Loans, particularly to companies, rose at the fastest pace in the second quarter of 2014 than at any time since the financial crisis. And banks now have more loans outstanding than they did before the financial crisis.

And what about the fact that the Volcker Rule makes the bank’s trading operations less valuable? Isn’t that the point? We are trying to encourage the banks to trade less and, as we said above, it’s only kind of working.

In the end, Volcker was not able to stamp out all risk in the banking system. But was that the point of the rule in the first place? Banks have to take risks to make money. They’re banks, not pet shops or daycare centers.

We want banks to take risks. But we want them to take risks in economically productive ways, like lending money to companies, even small businesses that might fail, not creating synthetic securities in order to make money on them when they fail. The Volcker Rule, at least for now, appears to have successfully forced banks to shift their risk.

Perhaps that’s not enough to make anyone cheer Dodd-Frank’s birthday, but you could at least be nicer to it. Four- year-olds are sensitive.