What Dismantling Dodd-Frank Can Do

By Peter J. Wallison.

The market bump from Donald Trump’s win is peanuts compared with what regulatory relief can bring.

The sharp rise in the Dow Jones Industrial Average after Donald Trump’s election could be short-lived, but based on what the president-elect has promised to do it is an accurate assessment of the U.S. economy’s prospects. All through his campaign, Mr. Trump said regulatory relief for the economy was a priority, including the repeal of the Dodd-Frank Act. Repeal or thoroughgoing reform of that destructive law is certainly a key step toward an economic recovery.

Signed into law in 2010, Dodd-Frank was based on the idea that insufficient regulation, particularly of Wall Street, had allowed a buildup of subprime mortgages, a housing bubble and, ultimately, the 2008 financial crisis. The Democrats who controlled the Congress elected in 2008 acted quickly to follow out the implications of this diagnosis by adopting Dodd-Frank, the most restrictive financial legislation since the New Deal.

Strikingly for such important legislation, there was no significant debate in Congress about whether the cause of the crisis had been correctly identified.

A later study, in 2014 by my colleague at the American Enterprise Institute Edward Pinto, showed that by 2008 more than half of all mortgages in the U.S. were subprime or otherwise risky, and 76% of those were on the books of government agencies. This leaves no doubt that government housing policies—and not a lack of regulation—created the demand for these risky mortgages. But by then it was too late.

It is not difficult to find connections between Dodd-Frank and the historically slow recovery from the financial crisis. Here’s a sampling.

The Financial Stability Oversight Council, a Dodd-Frank invention, was empowered to designate large financial firms as systemically important financial institutions, or SIFIs, turning them over to the Federal Reserve for “stringent” regulation. One of the council’s earliest actions, in July 2013, designated GE Capital as a SIFI.

GE soon recognized that its huge financial subsidiary was wilting under the Fed’s control. Seeking an exit, GE wound down GE Capital, eliminating from the market an important source of funding for small and innovative firms.

The Volcker rule, another Dodd-Frank provision, prohibited banks and their affiliates from trading securities for their own account, although there was no evidence that this activity had any role in the financial crisis.

Soon, trading desks all over Wall Street were closing down, and traders were complaining that the debt markets were dangerously short of liquidity. The Treasury Department, deeply tied into Dodd-Frank, said it was “studying” the issue. It still is, and spreads are still historically wide.

Small banks, the credit sources for small businesses and startups, faced new and costly regulation, requiring them to hire compliance officers instead of lending officers.

One regulation on mortgage lending from the Consumer Financial Protection Bureau—a Dodd-Frank agency—was over 1,000 pages long. Imagine that landing on your desk in a small bank.

No wonder, as this newspaper recently reported, banks are no longer the nation’s principal mortgage lenders. Worse still, as reported last week, job gains at startup firms, which are major sources of new employment and technological innovation, are at their lowest level in 20 years.

Fortunately, some reforms take care of themselves because of the people Mr. Trump is likely to choose for his administration. The Financial Stability Oversight Council (FSOC) is headed by the secretary of the Treasury and composed of the heads of all the major financial regulators. It is unlikely that Mr. Trump’s new Treasury secretary or any other new appointees will be interested in designating SIFIs, so that threat to the economy is probably off the table.

A bonus is that the Financial Stability Board, a largely European body of which the Treasury and Fed are members, needs an active FSOC in the U.S. to implement its plan for regulating what it calls “shadow banks.” The Fed and the Treasury have been driving the stability board’s effort on this, but are now likely to stand down. Shadow banks—which the stability board defined as all financial firms, of any size, without a regulator of their risk-taking—are safe.

Other provisions must be addressed with legislation. Fortunately, House Republicans have laid the groundwork. The House Financial Services Committee, under Chairman Jeb Hensarling, has already voted through the Choice Act, which would let banks avoid costly regulations by holding significantly more capital, and which substitutes a tangible asset-based leverage ratio for the complex Basel risk-based capital rules.

Once made law, the Choice Act will create a new, less costly landscape for small banks and help revive small businesses and startups with the credit they’ve lacked under Dodd-Frank.

The Choice Act also turns the Consumer Financial Protection Bureau—now headed by a single administrator accountable to no one—into a bipartisan commission, funded by Congress as the Constitution intended for all executive agencies. Rulings that require 1,000 pages to explain, produced without consulting anyone, should be a thing of the past. The act would also repeal the Volcker rule, returning liquidity to the markets for debt securities.

These are among the most important provisions of the Choice Act, but other initiatives might also be considered.

Dodd-Frank authorized the Commodity Futures Trading Commission and the Securities Exchange Commission to make rules for trading derivatives, including requirements for mandatory clearing of most derivatives transactions. Because mandatory clearing could make clearinghouses the sources of systemic risk, the FSOC voted to give them access to the Federal Reserve’s discount window, setting up another government backstop that will impair market discipline. The Trump administration should consider removing that backstop, together with mandatory clearing itself.

With a Republican House and Senate, President-elect Trump has an opportunity to eliminate many of the regulations that have held back economic growth. As Ronald Reagan used to say, “If not us, who? If not now, when?”

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