Deng Xiaoping, the Chinese leader who helped transform China from a planned economy to a market one, famously said in response to criticism that he had surrendered communist principles: “It doesn't matter if a cat is black or white, so long as it catches mice.”
So, too, with financial regulation and the ideological divide in Congress.
The Financial Choice Act sailed through the House of Representatives recently, part of a legislative effort to roll back large parts of the Dodd-Frank Act of 2010. While the legislation is right to do away with the overly burdensome regulations of Dodd-Frank, it is wrong to leave government without adequate tools to protect the financial system.
Instead of focusing on a few key regulations to make the financial system safer, Dodd-Frank threw the proverbial kitchen sink at the problem, and the costs of multiple, overlapping regulations accumulate with little additional marginal benefit. The Choice Act’s repeal of the Volcker Rule, loosening mortgage lending and reining in of the Consumer Financial Protection Bureau, among other steps, are worthwhile efforts to alleviate excessive compliance costs.
It is not just the direct cost of regulation that matters for the economy, but also the unintended impact on the financial sector’s ability to innovate. Given increased regulatory complexity, financiers find it difficult to experiment and “get their feet wet” in developing new products to solve real-world problems. At a recent conference, the Nobel Prize-winning economist Robert Merton described the incredible innovations that took place in finance in response to the various economic crises of the 1970s and then lamented how little had taken place since the 2007-9 crisis. While Dodd-Frank is not to blame for all of this, it certainly did not help.
The Choice Act offers a clever solution that should be sensible for all but the largest banks. The bill’s “off-ramp” exempts banks that are financed with enough tangible equity, as a percentage of assets, from many of the regulatory rules of Dodd-Frank. This idea is logical. If a bank is well capitalized, the benefits of regulation are smaller, because moral-hazard concerns are less important and bank equity holders are more likely to make efficient lending decisions.
But the Choice Act offers this same off-ramp to large systemic banks, which is a mistake: Some banks are just too interconnected and complex with multidimensional risks and opaque financial leverage for the off-ramp’s simple ratio of capital to assets to provide sufficient protection to the financial system. They need enhanced oversight. And the Choice Act’s specific capital requirement of 10% is at the low end of what should be considered for these firms.
Similarly, while the Choice Act can be commended for its focus on regulatory relief, the bill goes off the rails as it pertains to the identification and management of systemic risk. Sticking to a rigid ideology, the legislation views the existence of “systemically important financial institutions” (SIFIs) as resulting solely from the implicit government guarantees associated with designating them. It is as if the crisis runs of AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and Merrill Lynch — all outside the realm of banking oversight and SIFI designation back in 2007 — never happened. Indeed, the Choice Act would roll back systemic risk regulation by not allowing SIFI designation of these nonbanks.
In our view, several Dodd-Frank regulations need to stay in place: First and foremost is the annual stress test applied to all SIFIs. Because stress tests can uncover threats to the system as a whole when large financial firms are collectively under duress, reducing the testing frequency would substantially weaken one of the most effective tools for controlling systemic risk. Eliminating stress tests as part of the off-ramp could invite risk-taking that eventually fuels another severe financial crisis.
Second, the authors of the Choice Act argue that “risk-weighted” capital ratios have failed and choose instead a simple leverage ratio to measure bank resilience. While we are sympathetic to the difficulty of choosing risk weights, a simple leverage ratio merely sets the same risk weight across all assets; as a result, lending to a safe versus a near-bankrupt company would be treated equally. A more sensible plan would be to insist that the largest banks satisfy a risk-weighted capital ratio along with the off-ramp’s 10% leverage ratio. Third, as the recent financial crisis demonstrated, complex firms need enhanced supervision because these institutions have large off-balance-sheet exposures and potentially hidden leverage, depending on their derivatives positions and capital treatment.
In response to the various bailouts provided in the last crisis, the Dodd-Frank Act made it much more difficult for the government to support financial firms, even healthy ones, during times of stress. The Choice Act compounds this mistake.
For example, the Choice Act would replace Dodd-Frank’s Orderly Liquidation Authority with a new bankruptcy procedure especially designed for large banks. A more efficient bankruptcy procedure could promote market discipline, but it would be ineffective in the absence of authority for temporary government funding (equivalent to debtor-in-possession financing) during the bankruptcy process. The lack of such funding under the Choice Act ties the hands of the bankruptcy court. Instead, when a crisis hits, a future Congress will again be inclined to enact an emergency bailout law — just like the Troubled Asset Relief Program that followed Lehman’s 2008 failure.
Despite having passed the House, the Choice Act is unlikely to pass the Senate in its current form. That said, we need regulatory reform. Senators should put aside partisan politics and combine the best features of Dodd-Frank and the Choice Act to catch Deng’s “mouse” and create both a more efficient and a safer financial system. Americans deserve it.