Take the long view in assessing Dodd-Frank

Register now

In the post-recession period, U.S. economic growth has generally been viewed as lackluster. While annual growth of 3.8% was achieved between the 1990 and 2001 recessions, the economy has averaged a mere 2.2% annual growth since 2010. Many have placed the blame for reduced growth at the feet of the Dodd-Frank Act.

To address this question of whether the rules are acting as a brake on economic activity, we need to consider both the short- and long-term growth implications of bank regulation.

The short-term view proffered by most in the industry goes something like this: As a result of Dodd-Frank, banks, which provide the credit lifeblood for a dynamic economy, have diverted significant resources away from core lending activities toward tasks associated with regulatory compliance. Further, banks with assets above $50 billion are now required to maintain excessive levels of capital. If these dual burdens were withdrawn, banks would grow their loan books at a faster rate, businesses would invest more, consumption would boom — and the economy would grow at a significantly faster clip.

With only the short run in mind, and when viewed solely through a microeconomic lens, this view is fundamentally sound. Empirical studies generally confirm that bank-level credit supply is negatively impacted by high capital levels in a normal economy. Regulations that mandate banks to engage in activities they may not pursue of their own volition causes them, unquestionably, to deviate from the profit-maximizing path.

But the macro view of this situation is quite different. At this level, we must recognize that monetary policy, which sets the baseline interest rate against which all risky credit ventures are priced, has a far more profound impact on lending than any big-bank stress test ever could.

In 2011, one could have argued that Dodd-Frank enforcement was strangling growth: The federal funds rate was zero, successive rounds of quantitative easing were providing little meaningful accommodation and the economy was languishing. The Federal Reserve was simply unable to offset the negative impact of the stress tests by cutting headline interest rates.

However, the economy at that time was demand-constrained. Had the Fed taken action to increase the supply of credit by easing regulation, it likely would not have had much impact because businesses and households were simply in no mood to increase their levels of debt.

In 2018, by contrast, we have close to full employment, inflation appears contained and the Fed can sterilize the impact of any policy shift through rate cuts or more aggressive rate hikes.

The net result is that if stress test rules are loosened tomorrow, it will have very little impact on the observed rate of bank lending or of economic growth, though the future path of interest rates may well be affected. The question is whether it is preferable to have a tough stress test, low interest rates and moderate growth — or a lax stress test, higher interest rates and, you guessed it, moderate growth.

The long-run view is different again. Assume for a moment that Dodd-Frank really does act as a brake on short-term growth. Further, make the reasonable assumption that increased bank regulation reduces the probability of a recession induced by bank failure. Policymakers then have a choice between two distinct growth paths: Under deregulation, we will have faster growth during shorter expansions and larger contractions during more frequent recessions. Under the Dodd-Frank status quo, given the assumptions, we will have weaker sustained growth and a lower probability of deep recession.

On the face of it, this seems like a close call. Yet the empirical literature here suggests that the crippling of credit that occurs in recession is usually so great that, through the economic cycle, bank lending is actually higher with a stronger capital cushion. In other words, if the reduced probability of recession is factored in, and if monetary policy responses are fully accounted for, the evidence broadly argues in favor of maintaining a tough regulatory regime.

The evidence also shows that the volatility of growth is clearly higher under a deregulated banking system. Those of us who have weathered deep recessions understand the problems caused by higher volatility. Given that the promised boost to growth is so uncertain, ending Dodd-Frank in its current form appears to be too great a risk.

This is not to say that Dodd-Frank is perfect. There is clear evidence that the impact of regulation on small banks has not been carefully considered. One can also posit ways to make size thresholds more fluid to avoid the possibility that banks on the wrong side of a regulator-mandated threshold are disadvantaged relative to their marginally smaller peers.

Overall, though, Dodd-Frank is causing risk to be spread more broadly across the banking system. A reversal in these trends would bring few short-term benefits while making a repeat of 2008 all the more likely.

For reprint and licensing requests for this article, click here.