Though Congress has taken some steps, Dodd-Frank needs more reforming. A close look at its effects, now that enough time has passed to produce evidence, shows that it has created as many problems as it solved, if, in fact, it solved any problems. It is not that the financial system should go without disciplined control. Regulation is essential. The 2008-09 crisis showed that, as have earlier crises. But what the country got from Dodd-Frank clearly was not the answer. It has created inequities and shifted risk rather than reduce it, leaving the system as crisis prone as ever. As the evidence since its passage shows, it would do better to step back from micro controls on bank practices and find risk-control disciplines by putting financial firms, large and small, on notice that excessive risk could lead to their demise.
Generally speaking, Dodd-Frank’s deficiencies lie in two areas. First, its efforts to protect the system as a whole have created inequalities and inefficiencies that have otherwise distorted credit flows and may well have made the system less rather than more resilient than it was. Recent reforms of Dodd-Frank have begun to correct this flaw but only began to do so. Second, legislation from that time, by extending Washington’s habitual obsession with legal structures and institutional categories, has ignored many new financial actors, leaving them to step in where the rules discourage banks from going, creating risk for the system while the regulators look elsewhere. What is more, the risk remains at the banks, for even as the rules forbid banks to take on certain risks, they allow them to lend to non-bank actors who take on those same risks. Concrete illustrations can give a sense of the extent of these problems.
“Too big to fail” holds pride of place when it comes to Dodd-Frank inequities. It is easy to see the reasoning behind the legislation. Large institutions can threaten the efficacy of the whole financial system more than small, and so the government’s effort to protect the system offers them guarantees of a sort attached to stricter regulatory requirements. But as always is the case in such circumstances, the unintended consequences loom large. Despite the extra rules and the stress tests imposed on these large banks, the implicit government guarantee gives them a competitive edge over their smaller competitors that more than compensates. Potential clients cannot help but prefer dealing with guaranteed institutions. It is then far from surprising that since Dodd-Frank went into effect in 2010 the ten largest banks have increased their share of deposits from barely over 50% of assets to slightly more than 75%.
The inequity imposed by this “reform” goes still further. The law had originally set a relatively low size that would bring on extra rules and special scrutiny. Banks that rose above that level but still remained far below the huge, trillion-dollar-plus institutions faced the worst of both worlds, extra regulatory burdens but none of the advantages of the too-big-to-fail designation. Accordingly, smaller banks that contemplated mergers for business reasons hesitated for regulatory reasons. Merger activity declined by a quarter after Dodd-Frank. Because smaller institutions resisted growth, the Dodd-Frank “reforms” not only gave the mega institutions the competitive edge of a guarantee but also gave them shelter from the competition they might have otherwise arisen from up-and-coming regional players. By raising the bank size subject to extra regulatory scrutiny, recent legislation has moderated this effect but certainly not erased it.
A good example of how the Dodd-Frank rules shift rather than reduce risk comes from the repro market, where banks lend to each other short-term in order to support an even flow of credit and banking services. Dodd-Frank originally tried to control the risks in this area by demanding different amounts of backing for loans depending on the riskiness of the instruments used as collateral. Since, for example, regulators saw treasury bonds as safe, they allowed banks to borrow more freely with them as collateral than say, equity collateral, which the regulators considered riskier. These rules drew the banks toward safer assets, at least safer in the eyes of the regulators, who for some reason saw mortgage-backed bonds as safer than most assets, even though they played a big role in the 2008-09 financial crisis. New rules from the Bank for International Settlements look instead at overall leverage without discrimination. This would seem to put the onus on banks to determine which collateral has the greatest risk, but by also capping overall leverage, this “pure leverage” approach has driven banks to cut back on generally in lending to each other, even as they lean when they do so toward riskier if more profitable instruments for collateral, like equities. The banks, accordingly, have turned away from mortgaged-back collateral, allowing non-banks, which are not regulated, to fill the market gap by using mortgage-backed collateral in this activity.
It is apparent that the rules have neither reduced overall leverage nor the risk, in the mix of collateral. All they have done is shifted the risk among financial players. The system is no safer than previously. It is just that the risk lies in different quarters. The same effect emerges from Dodd-Frank’s treatment of what are called “leveraged loans.”
This lending consists of loans to corporate borrowers that already carry high debt levels. The risks are clear. Banks favor them anyway because they carry higher rates than most, ore than enough to compensate for the risk. Various regulatory bodies under the law offer guidance on such lending but neither prohibit it nor impose special penalties for making leveraged loans. When in 2015 regulators first issued guidance, large banks cut back on such lending. Small banks, which were not covered by the guidance, showed no change in their behavior. But because the demand for such lending remained unchanged, non-banks, also not covered by the guidance, stepped into the breach left by the large banks. Previously, large banks averaged 185 such loans a month totaling $25.1 billion. After the guidance went into effect, they averaged only 142 loans totaling $19.4 billion. Over the same time, non-banks have raised the pace at which they have made leveraged loans from 23 a month to 32 and the dollar amount from $1.5 to $2.8 billion. Their actions have not completely filled the gap left by the large banks, but they do constitute a substantive jump nonetheless. Risk to the financial system, in other words, has hardly declined. It has simply shifted. And since the non-bank lenders financed their loans largely by borrowing from the banks, they have the exposure anyway, indirectly to be sure, but it remains nonetheless.
A further examination of other aspects of the financial system would add to the number of illustrations. The regulators clearly need to jettison their focus on legal and institutional classifications and regulate all players equally. That way, their rules, for better or worse, would at least encompass the whole system rather than influence only parts of it. The way risk slides might also alert them to the need to embrace the ultimate risk-control discipline on lenders: the real possibility of bankruptcy. Too big to fail and other less obvious promises of government support or protection invite financial players to take risk. Rather than elaborate standards, especially if applied unevenly, more effective bankruptcy rules could protect the system by putting financial managers on notice that they and their shareholders could pay the ultimate price for excessive risk taking.
Originally published on Forbes.com.