BankThink

Regulators Should Practice Civil Disobedience of Dodd-Frank

Thanks to Dodd-Frank and other mandates, "we have hundreds of rules, many of which are uncoordinated and inconsistent with each other," JPMorgan Chase chief Jamie Dimon recently lamented. "While legislation obviously is political, we now have allowed regulation to become politicized."

He's right. And we don't need to repeal Dodd-Frank to fix at least part the problem. Instead, regulators should use their discretion under Dodd-Frank to act without discretion. In doing so, career regulators can rescue their reputation back from Congress.

What caused the financial crisis? Oh, lots of things.

But a big factor was that government central planners, rather than free markets, decided what was risky and what was not. Nudged by politicians, regulators determined, for example, that certain mortgage-related securities must be perfectly safe, thus allowing financial institutions to borrow oodles of money against them. Congress also forced regulators to treat some derivatives differently from others, even though, absent consistent limits on borrowing, they could all pose unacceptable risk.

You would think, then, that Congress and President Obama would have learned from these past mistakes. They should have admitted that the government simply wasn’t very good at determining what was safe and what wasn't – and said that they would no longer try.

They should have said that they would impose consistent, clear limits on financial firms and financial instruments, making all financial firms carry a certain percentage of capital against their borrowed money no matter what their perceived risk, for one thing.

Instead, Congress and the president blithely doubled down on their past errors. Just think about one provision of Dodd-Frank.

The law gives a new acronymed board – the Financial Stability Oversight Council, or FSOC – discretion to figure out which nonbank financial firms are "systemically important financial institutions" – SIFIs – and which are not. (Big banks like Dimon's are automatically SIFIs.)

This task is so complicated that nearly two years after Dodd-Frank became law, the smartest people in the world – Treasury Secretary Tim Geithner and colleagues from other regulatory bodies, who sit on FSOC – are still figuring out exactly how to do it.

Last week, they issued a 93-page rule to explain the process. It took them 93 pages to say that they'll look at big financial firms carefully to decide if they're risky or not, then give the firms an opportunity to say they’re not risky, then vote, then, perhaps, discuss it all over again and vote again.

They don't expect to finish this process anytime soon – likely not until the end of this year. And after that, they still have to decide what, exactly, to do with such "risky" firms: ask them to hold more capital? Ask them to submit additional reports to the Fed and the Treasury? Break them up?

What Geithner and colleagues should do instead is say that it's FSOC itself – a nonbank firm if there ever was one – that poses an unacceptable risk to the financial system and the economy.

Why? Regulators should say that it is simply impossible for a small group of people, vulnerable not only to political and private-sector pressures but to groupthink and herd mentality, to figure out what poses a risk and what doesn't. Only markets can do this job.

Moreover, markets can't do the job if regulators try to do it for them. Designating firms as SIFIs immediately sends a signal to the market that it's the government, not investors, that is responsible for making sure that these firms don't fail. The market then will figure that regulators would never let a SIFI go through bankruptcy, as such a failure would be a signal of government failure.

Government acceptance of systemic risk only compounds it.

To remedy the systemic risk at FSOC, Geithner et. al. should say that FSOC will de-risk itself by saying that no nonbank is systemically risky. He should then say that it is the policy of the U.S. government to have other rules and regulations in place that mean that any firm can fail, without taking down the rest of the economy.

Regulators should also say that though it's not their fault that Congress is making them designate big banks as systemically risky, their extra regulatory mandate on such banks will be … nothing.

Geithner can say that it is also the policy of the U.S. government to treat all banks alike, big or small – meaning that if one gets into a lot of trouble, it won't get any special treatment for its bondholders and counterparties. Such a statement would send the right signal to the market.

The fact that Congress gave regulators lots of discretion shows that politicians trust the experts to do the right thing. The experts should know that the right thing to do is to give up their discretion – so that markets, not bureaucrats, can pick winners and losers.

Nicole Gelinas, a Chartered Financial Analyst, is a contributing editor to the Manhattan Institute’s City Journal. She tweets @nicolegelinas 

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