Dodd-Frank can help prevent revisiting the recession
Maintaining reform act will allow regulation of 'shadow banking'
April 13, 2017
Filed under Opinion
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The Dodd-Frank Wall Street Reform and Consumer Protection Act was put into place as a direct result of the Great Recession of 2008. The law changes regulation in virtually every facet of the financial industry, from things like creating the Consumer Financial Protection Bureau and increasing the transparency of derivatives training. The bill was passed in mid-2010, almost exactly along party lines, and has been hotly debated ever since.
President Donald Trump plans to scale back the law. He believes that the law went too far and is making it virtually impossible for small businesses to receive the loans they need to grow their businesses. It is unclear whether Trump plans to completely repeal the law or just small parts of it. After the failure of the plan to replace Obamacare, the latter seems much more likely.
Then the question is: what parts of the law get repealed? The biggest likely target is the Volcker Rule, which bans deposit-taking institutions from participating in speculative proprietary trading. In English, this means that banks that take deposits, such as your checking and savings accounts, cannot invest their own money into the markets.
This is the kind of trading that partially caused the financial crisis, according to economist Paul Volcker. This kind of trading created a system of private gain and public loss. When the banks bet correctly, they would pocket their winnings, but when they bet wrong, the federal government has to step in to bail them out.
Another likely target is the fiduciary rule. This rule would require financial advisers and brokers to put your interests in front of theirs. Currently, they only have to recommend assets that are roughly suitable to what you need. If one charges a higher yearly fee, they will suggest that one. The rule seems like common sense to me — your financial adviser’s job is to help you manage your money in a way that will put you in the best place for retirement. Even if the rule is repealed, I would hope that consumers will advocate that some sort of fiduciary clause is embedded into the contract signed when the adviser-advisee relationship is created.
Janet Yellen, the chairwoman of the Federal Reserve, recently reaffirmed her support for the act. She feels that the law has improved the safety and stability of the industry and will help minimize both the risk and impact of a future recession. This can easily be shown through changes in the asset-liability management ratio.
In a 2016 article, former Senior Deputy Comptroller of the Currency Martin Pfinsgraff, ’77, said that the ALM ratio shows the percentage of a bank’s holdings that are in safe categories. He showed that from before the crisis in 2007, to recently in 2015, banks have gone from holding 52 percent in 2007, to 96 percent in 2015. Although this is partially from banks becoming more cautious, much of the decrease in risk is a direct result of the Dodd-Frank regulation.
The Federal Reserve bank of Minneapolis argues that even more regulation is necessary. They argue that Dodd-Frank decreased the chance of a bailout from 84 percent to 67 percent, but with their suggested regulations, the chance of a bailout could drop as low as nine percent. They believe that the “too big to fail” issue is one of the most serious long-term issues for the U.S. economy.
Many banks are so large that their failure would lead to large systematic shocks that could cripple the economy. Essentially, the Federal Reserve bank of Minneapolis suggests that banks are required to hold onto more liquid equity. This means that in an event of a crisis-level event, the banks could quickly turn this equity into cash and use it to prevent a catastrophic failure of the bank. Another big step of the plan is regulating the “shadow banking” sector.
This sector includes things like mutual funds and private equity firms which are currently performing bank-like activities, while not being subject to the same level of regulation and scrutiny that banks are required to face. The goal of this step is keep banking activities “in the light” so that everything is as safe as possible.
Dodd-Frank is not without its issues. It is putting a large strain on smaller community banks. These banks generally do not participate in any kind of risky behavior and only seek to benefit the businesses and people in their community. The Minneapolis plan addresses this issue by removing many of the Dodd-Frank restrictions on community banks.
My hope is that much of Dodd-Frank ends up staying in effect. If repealed, risk levels would quickly jump back to pre-recession levels, and we will end up in a similar situation. Those who do not learn from history are destined to repeat it.