The US is at a critical juncture for financial regulation

Financial regulation in the United States is at a critical juncture. Federal Reserve Board Governor Daniel Tarullo, the unofficial czar of financial regulation, has just resigned. A new draft of the Financial CHOICE Act, the leading proposal to replace the Dodd-Frank Act, will be introduced this month. The country needs to decide now on the future of financial regulation.

The most burdensome parts of Dodd-Frank should be eliminated, but the government must have regulatory tools to protect the financial system. In particular, the following key issues need to be resolved correctly.

{mosads}Create an “Off-Ramp” for smaller banks but not for the largest banks. The CHOICE Act’s off-ramp exempts banks that are financed with a specified minimum level of equity from the more complex rules of Dodd-Frank.

Despite Dodd-Frank’s intentions, smaller banks—whose failure would not threaten the financial system—have been heavily burdened by extensive reporting requirements, a proliferation of rules, and multiple regulators with overlapping jurisdictions. For these banks, a simple, equity-based off-ramp is a good idea.

There should be no off-ramp, however, for the few dozen very large and complex banks. These banks should be required to rely less on debt and more on equity funding. But their multidimensional risks cannot be captured by a simple ratio of equity to assets and their failures would threaten the financial system. Furthermore, an off-ramp should not unduly weaken stress tests, through which regulators assess the viability of large financial institutions in crisis scenarios.

That regulators failed to foresee or prevent the last crisis does not justify the elimination of effective supervision. Financial markets—embodied by managers of large financial institutions, rating agencies, and professional asset managers—were equally bamboozled. By the same token, complaints about the challenges stress tests pose for bank management should be addressed without weakening the tests.

Government should have authority to designate non-bank as SIFIs through an appropriately rigorous process. Dodd-Frank allows the government to designate private, non-bank businesses as systemically important financial institutions (SIFIs) and then subject them to strict oversight. This is an extraordinary power, and it has been argued that some designation decisions have not met an appropriately high standard of analysis.

But large, non-bank financial institutions can pose as much risk to the financial system as banks. In 2008-2009, concurrent bankruptcies of mortgage giants (Fannie Mae and Freddie Mac), of stand-alone investment banks (Bear Stearns, Lehman Brother, Merrill Lynch, Morgan Stanley, and Goldman Sachs), and of insurers (AIG) would have crippled the system as surely as the failure of large banks.

Therefore, subject to a rigorous and properly vetted process, which includes a high analytical bar, government should have the power to designate SIFIs.

There must be a plan to resolve SIFIs in crisis, which may require temporary government funds. Dodd-Frank’s Orderly Liquidation Authority (OLA) empowers the FDIC to restructure or liquidate a troubled SIFI when conventional bankruptcy would be too slow or unworkable. The SIFI’s management would be fired; claims of equity holders and creditors would be wiped out; and the government could make temporary loans to ensure an orderly resolution. Furthermore, to prepare for such an eventuality, SIFIs must submit Living Wills that detail how they could be wound down in a crisis.

The OLA and Living Wills are controversial. First, OLA gives discretion to government officials over an untried process. Second, the availability of government funds might perversely increase the likelihood of a SIFI’s failure through moral hazard—that is, the weakening of market discipline imposed by private stakeholders. Third, the process for judging the adequacy of Living Wills has been criticized as arbitrary and opaque.

The CHOICE Act would replace the OLA with a new bankruptcy process dedicated to SIFI failures. It would exempt banks that take the equity off-ramp from having to submit Living Wills.

The independence and well-established procedures of bankruptcy courts are strong reasons to replace the OLA with a faster and more efficient bankruptcy chapter. But that is not enough to contain a crisis. History shows that U.S. authorities and lawmakers—despite statements or even legal commitments to the contrary—will intervene to forestall the collapse of the financial system. Planning is therefore imperative—both through Living Wills and the availability of temporary government loans—to facilitate orderly resolution. The inevitable moral hazard should be addressed by regulating, supervising, and imposing the dire outcomes of bankruptcy on SIFI investors. 

Repeal the Volcker Rule. Dodd-Frank banned banks from proprietary trading and from investing in private equity funds and hedge funds, but this provision never had much to do with risks to the financial system. Under the Volcker Rule a bank can make and trade corporate loans, but cannot buy and trade corporate bonds, or invest in funds that do so, even if the risks are identical. Moreover, the difficulty of specifying permissible trades and investments has led to complex rules and costly compliance efforts while doing little to make the financial system safer.

The Volcker Rule should be repealed because risk can be reduced at much lower cost through other supervisory and regulatory tools.

In short, at this critical juncture of financial regulation in the United States, a combination of the best features of Dodd-Frank and the CHOICE Act will foster both a more productive and a safer financial system.

Matthew Richardson, Kermit Schoenholtz, Bruce Tuckman and Lawrence White are professors at the NYU Stern School of Business and are the editors of the recently published book, Regulating Wall Street: CHOICE Act vs. Dodd-Frank.

The views expressed by contributors are their own and are not the views of The Hill.