Glenn Hubbard: Dodd-Frank Doesn’t Work, But This Plan Could
In an important speech before the Economic Club of New York this week, House Financial Services Committee Chairman Jeb Hensarling (R-TX), offered a new approach to financial regulation — an alternative to the Dodd-Frank Act that balances growth and risk-taking with Dodd-Frank’s focus on safety and soundness.
Concerns over credit availability, consumer financial access, and lack of regulatory accountability have led to mounting frustrations with the cost of Dodd-Frank’s regulatory micromanagement and with the idea that the Act’s safeguards against a future crisis are likely weak. The plan outlined by Hensarling recognizes that financial deregulation is not the answer but that regulation must preserve the golden goose of the financial crisis.
Currently, the law’s 2,300-plus pages of regulatory text rests on the foundation that the financial crisis was caused by insufficient regulation. Economists, by contrast, point to sharp asset price increases helped by ultra-low interest rates, risk premia in global capital markets, as well as credit-risk perceptions that were distorted by regulatory reliance on ratings and risk-weightings that suggested financial alchemy, and ultimately contagion across financial institutions leading to fire sales of assets.
However, as the House Financial Services Committee plan observes, Dodd-Frank fails to remedy areas of public anger over the crisis. Financial institutions are still too big to fail, while consumers need more financial protection.
For instance, Dodd-Frank readies a costly bailout system called the Orderly Liquidation Authority to confront a doubling down on too-big-to-fail firms, now called Systemically Important Financial Institutions, or SIFIs. In so doing, the law substitutes regulatory micromanagement for market discipline coupled with a more rigorous means of resolving the failure of a large complex financial institution.
Meanwhile, the Consumer Financial Protection Bureau fails to balance credit availability and financial access with regulatory concerns for consumer protection, while remaining essentially unaccountable to the Congress’ power of the purse, drawing funds from the Federal Reserve with no legislative appropriation.
At the top of the Dodd-Frank regulatory edifice lies the Financial Stability Oversight Council, or FSOC, composed of regulators already responsible for portions of the financial system before and during the financial crisis. Despite public calls for regulatory transparency in the aftermath of the financial crisis, the FSOC acts as prosecutor and judge in designating too-big-to-fail firms and has the power to reorder contractual priority in the financial distress of such a firm.
So the question remains: are we now safer because of Dodd-Frank? The answer is likely ‘no’ for a number of reasons. Dodd-Frank’s restrictions on banks’ roles in market-making has dampened liquidity in bond markets, a potentially serious mistake in the event of escalating asset sales, as we saw during the crisis. The Federal Reserve’s ability to intervene in a future crisis has also been circumscribed by Dodd-Frank.
The proposal outlined by Chairman Hensarling starts with a different foundation from Dodd-Frank in many respects. The law relies on the belief that explicit rules and regulation ex ante make a crisis much less likely, with little flexibility ex post to deal with a crisis if one happens. By contrast, the House proposal is more humble about the ability of regulation to address all problems in a complex and dynamic industry, offering market discipline as a counterweight. The proposal would permit financial institutions with limited leverage and strong core capital, including stocks and reserves,to be subject to less regulatory micromanagement. Such an approach, especially if complemented by a role for contingent convertible bonds, prices of which send important signals about a financial institution’s health.
To be sure, the plan is imperfect; two areas, in particular, deserve further discussion. First, while the plan would repeal Titles I and II of Dodd-Frank to end taxpayer-financed bailouts, strong consideration of a realistic alternative resolution mechanism is needed, as one scholar, Kenneth Scott, at Stanford Law School has suggested. Second, the prospect of contagion means that ex post means of intervention by the Federal Reserve and the Treasury must remain possible in a crisis.
Finally, the Act rightly focuses on the need to foster greater accountability. Such accountability must focus on Wall Street, of course, so that wrongdoing and consumer fraud are punished. But it must also focus on Washington, where Dodd-Frank has weakened regulatory transparency and accountability to Congress both in budget and in trading off costs and benefits of alternative regulatory approaches.
GlennHubbard is dean of Columbia Business School. Previously, he served as chairman of the Council of Economic Advisers under President George W. Bush.