The Dodd-Frank Act improved several aspects of the U.S.'s regulatory framework, creating or enhancing tools like stress tests, the Office of Financial Research and prudential standards to avoid the specific pitfalls of the last crisis. However, in the important areas of regulatory parity and shadow banking, it makes only a down payment.
For all Dodd-Frank's new rules, many areas of glaring disparity remain, where banking institutions get tougher treatment than other firms doing the same activities. The result is a two-tier financial system, with one set of heavily regulated banks and systematically important financial institutions, and another set of their less-regulated peers.
The disparities are more numerous and simpler than one might expect. Hedge funds can trade on and off balance sheet, build their firms and businesses on huge leverage and, even after Dodd-Frank, largely avoid regulatory scrutiny. Credit unions perform many of the same activities as banks, but pay no federal income tax. They receive no oversight from the Federal Reserve or the Federal Deposit Insurance Corporation and under the cooperative exemption, the Commodity Futures Trading Commission forgoes regulation of many of them. Large insurance companies may be specifically designated for Federal Reserve supervision, but smaller ones are not. No real estate brokerage is subject to the Consumer Financial Protection Bureau.
A firm that falls into these categories can still issue stock and obtain funding from individuals and institutions. It can lend money and engage in capital markets activity, including structured finance. And it can do all this without Fed oversight or, in most cases, bank-like supervision. It need not meet the new Basel III capital requirements. It can avoid limitations on leverage if it doesn't trade on an exchange — and, even if it does, its affiliates don't face the same limitations. All the while, it isn't subject to the discipline of stress tests, living wills or, in some sectors, rigorous examinations.
Many aspects of this disparate treatment are long–established, if highly problematic. The favorable tax treatment of credit unions, for example, is popular in some circles. Indeed, when "Bank Transfer Day" came along, credit union advocates urged customers to join credit unions, not community banks. Dodd-Frank left state supervision of most of the insurance industry largely untouched, and there was little protest.
But regulatory parity cannot be a matter of playing favorites. It must be about protecting the financial system. The dynamic between a regulated sector and a deregulated one is problematic, almost by design. Neither one of them operates in a vacuum. Higher leverage and lower compliance costs lead to better terms, easier pricing, a better proposition for prospective employees and faster growth. The regulated sector must lower its standards to compete, or provide services to the unregulated sector, until both of them are tightly intertwined. These pressures create a combustible mixture that can hurt both the regulated and the un-or-under-regulated sector.
Congress and the Financial Stability Oversight Council should take steps to redress this imbalance before it is too late. The fundamental principle of regulation and supervision should be "same size, same activity, same regulation and supervision." Only by following that principle can we truly regulate for financial stability.
Eugene A. Ludwig is a founder and the chief executive of Promontory Financial Group LLC. He was the comptroller of the currency in the Clinton administration.