In a 2010 book on the financial crisis, federal judge Richard Posner decried the rush to reform then sweeping Washington. "Before ambitious plans are hatched," he wrote, "with the inevitable delays and confusion and unintended consequences, there is first the need to assure that regulators are employing their existing powers to the full." Reform, he wrote, requires cool heads and rational minds and time to develop appropriate remedies.
Posner was not confident that cool heads would prevail.
He was right to worry: These are anxious times. Six years after the crisis, the economy is only slowly recovering and household wealth continues to fall. Amidst other national concerns, financial regulatory reform is a backburner issue. It shouldn't be. The Dodd-Frank Wall Street Reform and Consumer Protection Act was a noble effort at reform. But ambitious plans have spawned unintended consequences, perhaps the most important of which is that having made the effort, we now believe we have completed the task of ensuring the health and efficiency of the financial system.
Take community banks, institutions that Main Street has long relied upon to provide banking services to local businesses and consumers. American banks have been consolidating for decades, but community banks are being driven to the wall by over-regulation and compliance burdens. Between Dodd-Frank's passage in 2010 and late 2013, small banks' share of U.S. banking assets has declined 18.6%, and 650 of them have disappeared. As Kansas City Federal Reserve President Esther George warns, "Communities that rely on smaller banks for access to credit are feeling the weight of regulatory burden."
Meanwhile, the five largest U.S. bank holding companies' share of assets grew over 10% from early 2007 to mid-2014, to 46%, according to our findings in a working paper for the the Mossavar-Rahmani Center for Business and Government to be publishedin January.
Big banks are better equipped to handle Dodd-Frank's complex web of regulatory burdens. But the costs of doing so also harm the American public by diverting resources away from building businesses, making loans or rewarding consumers and shareholders. Standard & Poor's estimates the eight largest U.S. banks will spend $22 to $34 billion annually in compliance costs. Since 2010, the banking industry employs 13% more lawyers and 17% more compliance officers, according to data from the U.S. Bureau of Labor Statistics.
Some rules have driven businesses like subprime mortgage servicing and certain specialty lending services out of the banks entirely. This represents a steady erosion of the banking franchise. While this development provides an opportunity for new players to meet a need, it also means new providers are operating under regulatory uncertainty and an uneven regulatory terrain.
The Financial Stability Oversight Council the multi-regulator council created by Dodd-Frank has been handed the task of monitoring financial stability. It is early, but the Government Accountability Office finds it still "lacks a comprehensive, systematic approach" to do so. Complicating matters, the FSOC's authority to designate nonbanks and "activities" as systematically important, subject to heightened rules, is very broad. Consequently, insurers, asset managers and money-market fund managers now face a climate of regulatory uncertainty.
And what will happen when the next crisis comes? Dodd-Frank explicitly bans bailouts like the Troubled Asset Relief Program, which halted the system's implosion, albeit at the risk of creating moral hazard, and limits the Federal Reserve's ability to respond. In short, we have built a too-big-to-fail system while saying, "If it catches fire, we'll let it burn."
The debate over how U.S. finance should be regulated is one we've have had, off and on, starting with Alexander Hamilton and Thomas Jefferson. Today, crucial points are getting lost in discussions of reform. The thousands of pages required to describe and implement Dodd-Frank embody the law's paradox: an attempt to instill order instead created regulatory arbitrage, ambiguity and unintended consequences, all at great cost to banks, consumers and taxpayers. By comparison, the Glass-Steagall Act in 1933 was just 37 pages long. Dodd-Frank's complexity was not just the result of fierce lobbying. It came about because regulation and regulatory structure are not tied effectively together. Regulatory processes must be streamlined and optimized, even consolidated.
This is easier said than done, and the larger questions this proposal raises are difficult ones. How centralized should our financial system be? How can regulatory processes be reorganized and improved? How should we approach intervention in a crisis and minimize weekend bailouts and toxic politics? Each of these questions involves tradeoffs between moral hazard and safety and soundness, between efficiency and prudence. Answers must be unpacked and linked to consequences, intended or otherwise.
In the aftermath of the crisis, we stagger about in a tangled undergrowth of financial regulation. Without a larger sense of what banks are for, how Wall Street and Main Street should interact and how we should marry individual enterprise to collective needs, we're lost. Airing these issues, examining their premises and tying them to current realities will not necessarily provide us with a solution to all of our problems. But it would be a good start.
Marshall Lux is a senior fellow at the Mossavar-Rahmani Center for Business and Government at Harvard University's John F. Kennedy School of Government. Robert Greene is a research assistant at the Mossavar-Rahmani Center and a Master in Public Policy student at the Harvard Kennedy School. In January they will publish a working paper on the state and fate of community banking.