World Class Faculty & Research / June 17, 2015

Dodd-Frank Is Turning Five: Did It Deliver?

SMITH BRAIN TRUST -- The fifth anniversary of the landmark Dodd-Frank legislation, Congress's response to the financial crisis of 2007-08, arrives next month, prompting reflections on whether it has done what the Democratic-controlled Congress that passed it intended: Increase transparency and accountability in the banking system and — most importantly — reduce the likelihood of another crisis.

Draft legislation put forward by the Senate Banking Committee Chairman Richard Shelby (R.-Ala.) proposes sweeping changes to the law in this anniversary year, notably an increase in the amount of assets a bank must hold before being designated as "systemically important."  He would move the bar from $50 billion in assets to $500 billion.

Dodd-Frank, a sprawling endeavor, contains many positive or unobjectionable measures, says Mike Faulkender, a professor of finance at the Robert H. Smith School of Business, at the University of Maryland. These include clarifying that the government can resolve bankrupt bank-holding companies, as opposed to only individual banks, and requiring that risky financial instruments be traded through clearinghouses, which helps to clarify banks' risk exposure.

Still, Faulkender says, alluding to Shelby's proposal, "The notion that we need to relieve small and community banks of some of the requirements in Dodd-Frank is warranted. From a macro perspective, smaller firms have historically led us out of recessions, and smaller firms are more reliant on community banks for financing than large institutions are."

Because of scale, regulatory compliance ends up proportionally more expensive for small or midsized banks. "And to a large extent, those banks are not even engaging in the activities that Dodd Frank is concerned about" — such as finding buyers for complex securities. And if such banks took undue risks and failed, that failure would be unlikely to send shock waves throughout the economy.

The $50 billion threshold for systemically important institutions sweeps up enterprises such as SunTrust Banks, which is not a Wall Street giant but hardly a small-town bank, either. (Banks branded with the "systematically important" designation must undergo "stress tests," which leads to them holding more capital, and they must devise plans for their own demise — so-called financial living wills.)

But even banks below the $50 billion threshold can end up being affected by regulations intended for larger banks, Faulkender says. "When I talk to small banks, part of the problem is that regulators adopt Dodd-Frank principles as best practices and implement them even where not required. Shelby seems to want to send a message to regulatory agencies that they should loosen up on small banks."

From the start, defining "systemic importance" by asset volume was problematic; assets are only a rough proxy for economic interconnectedness, Faulkender says. The U.S. Treasury's Office of Financial Research is working on better measures of interconnectedness, but an asset threshold does have the advantage of simplicity.

Dodd-Frank enshrined the Volcker Rule, which forbids banks from proprietary trading — making bets with their own capital, as hedge funds do — but they are still encouraged to to "make markets," or connect buyers and sellers of assets. "But the problem you get with the Volcker rule is that it's not always clear where proprietary trading stops and market making starts," Faulkender says. "And that's going to cause banks to be excessively risk averse." If a bank does not have enough buyers for an asset, at a given price, it might hold the asset as a "residual."

Is that the bank taking a position, which would be forbidden, or making a market, which is encouraged? Banks may conclude the former, and decide not to act. And if banks shy from market-making activities, that can lead to a dangerous breakdown in liquidity for some securities, spooking investors.

Specific provisions of the law aside, Faulkender says: "To me, the fundamental flaw in Dodd-Frank is that I have yet to have a regulator explain to me how the financial crisis would have been averted had all the machinery of Dodd Frank been in place in 2007. The core of the financial crisis was mortgage financing, and Dodd-Frank is entirely silent on mortgage financing. It does nothing about Fannie Mae and Freddie Mac."

"Not only that, but the bias at the time of the crisis — for regulators as well as Members of Congress — was that housing was something regulators needed to facilitate. Regulators were basically lax on the financial institutions that were facilitating the expansion of mortgage capital. And given the history of housing prices, regulators as much as if not more than the banks themselves underestimated the potential downside risk. So even with all this additional regulation in place, why would regulators have halted any of the activity that was going on? It seems a lot of what Dodd-Frank does is to replace the judgment of the banks with judgment of the regulators. And I'm not convinced that that that improves the system."

If we could turn the clock back to 2010, Faulkender would impose higher capital requirements on all banks, which he believes would be a more equitable way to incentivize prudence. But neither Congress nor the banks were receptive to that alternative, preferring more-intense regulation. "I think I'm in agreement with the cynics who say that the big banks and the regulators are the biggest beneficiaries of the choice Congress ended up making," Faulkender says.

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