Policing the Street

For decades, investors were perfectly happy to part with their savings and allow Wall Street to operate comparatively unhindered, in exchange for high rates of return. The 2008 financial crisis changed all that. As America limped away from near economic Armageddon, government officials worked to address deficiencies in the financial system. Liberals clamored for strict regulation of Wall Street excess, while conservatives remained apprehensive about constraining the financial sector during recession. What emerged from the fight were the Dodd-Frank Act and Basel III standards, proposed regulations from domestic and international policymakers respectively. However, while officials were well intentioned in their goals, their products, particularly Dodd-Frank, are misdirected overreactions to a crisis that do little to solve underlying problems.
The Dodd-Frank Morass
During the 2008 presidential campaign, then-Senator Obama campaigned on reforming the financial sector. In the summer of 2010, Congress produced the Dodd-Frank Wall Street Reform and Consumer Protection Act, the most extensive expansion of financial regulation since the Great Depression. Dodd-Frank aimed to end “too big to fail,” an understanding that some financial institutions are deemed too integral to the nation’s financial health to be permitted collapse. Politicians hoped to spare taxpayers from the costs of rescuing ailing firms from the consequences of their risky investments. By this measure alone, however Dodd-Frank has failed. As Harvard Business School Professor David Moss points out, “If you really want to eliminate ‘too big to fail,’ ultimately you have to eliminate ‘too big.’” Although regulations preventing financial institutions from growing above a certain size too large may reduce the need for bailouts, the tradeoff is unattractive. Large firms may create systemic risk in the market, but they also offer services no combination of smaller firms can provide.
Altogether, Dodd-Frank calls for about 350 new rules to be written by regulatory agencies, mostly the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission. The law gives agencies an unrealistically compact deadline and has caused them to rush a series of extremely complex new regulations. The short timeframe thus prevented the agencies from fundamentally analyzing the impact such rules would have, or how to effectively implement them. As Harvard Law professor Hal Scott explained, “That is fatal, because the D.C. Circuit [Court] in Washington recently threw out another SEC regulation, the proxy-access rule, because they did not do adequate cost-benefit analysis.” The court’s precedent threatens every rule the agencies formulate under Dodd-Frank, as companies dissatisfied with the unanalyzed restrictions enjoy a reason to challenge them. Lack of clear jurisprudence creates further uncertainty in the economy, leaving financial institutions reluctant to change their business practices.
An Authority to Fly?
A rare bright spot in Dodd-Frank is its consolation of financial regulation into a few agencies to fill in the grey areas that plagued existing regulatory structure. The law empowers the new Financial Stability Oversight Council (FSOC) with broad authority to identify and monitor excessive risks to the U.S. financial system arising from the distress of large, interconnected firms. Limiting the systemic risk created by firms is at the heart of what new regulation should address, but there are many who remain skeptical about the council’s effectiveness, particularly its ability to enforce its mandate. While the FSOC has the authority to monitor systemic risk, they have no mandate. As one Harvard economics professor remarked, “I can give you the authority to jump out of the window and fly, but I’m not sure if you’d want to try it.”
Indeed, the only thing worse than poorly designed regulation may be unenforced good regulation, a factor that many economists cite as a contributing factor to the current crisis. Harvard Business School professor David Moss states, “Over time, regulators may have begun to take prolonged stability for granted and become complacent, particularly in the lead up to the crisis.” Long periods of financial stability lure officials into a false sense of security, and regulators can irresponsibly shirk their duties, while Financiers push the envelope in pursuit of profits. Unless the regulations created under Dodd-Frank are crystal-clear and enforceable, Wall Street could very well find itself at the epicenter of another crisis.
Basel III
The financial regulatory zeal has metastasized beyond Dodd-Frank. Once the financial crisis spread across the globe, the Basel Committee on Banking Supervision began to formulate entirely new solutions to the shortcomings of existing regulation. In summer 2011, they finalized the Basel III regulatory standards, which increase minimum capital requirements for banks, among other things. The increased capital buffer would reduce risk, but also make banks less profitable, in that the mandate requires that institutions keep more cash in reserves. The largest institutions would face an additional capital surcharge, resulting in an extraordinarily high 9.5 percent buffer. Even one of President Obama’s allies on Wall Street, J.P. Morgan CEO Jamie Dimon, has called the proposition “blatantly anti-American.”
Paralleling the controversy surrounding Dodd-Frank, economists ask questions about the effectiveness of Basel III. All regulation has macroeconomic consequences, and here the costs potentially outweigh the benefits. The Organization for Economic Co-operation and Development estimates that the implementation of Basel III will decrease annual GDP growth by .05 to .15 percentage points. Scott states, “I don’t have a lot of confidence that Basel III equals financial stability, but I’m very certain that Basel III equals less banking activity and less economic growth, so I’m not willing to sacrifice hardly any GDP growth for Basel III”
Basel III will not be fully implemented until 2019, potentially providing valuable time for officials to tailor its provisions to minimize their adverse economic impacts. Additionally, because Basel III would affect most western nations, American banks would not necessarily find themselves at a disadvantage against their counterparts like Deutsche Bank and BNP Paribas. The Federal Reserve has signaled that it is receptive to implementing some of the proposed constraints, which Fed representative Mark Van Der Wiede declared, “not only toughens reforms but also leaves the playing field relatively level.” When implementing the reforms, nonetheless, U.S. officials must take caution in avoiding the mistakes still extant in Dodd-Frank.
Looking Forward
To be sure, regulation has its limits. The only way to completely prevent the next financial crisis is to eradicate the financial system. As this may prove imprudent, policymakers should instead aim reduce crises’ frequency and magnitude. Dodd-Frank and Basel have attempted as much, but misdirected policies and poor implementation still threaten economic growth. Instead of focusing on stabilization, some policymakers have sought retribution against the financial sector, at a cost of making the economy worse off than before. While greater oversight of the powerful financial services industry is essential, prospective rules-makers should not rush headlong into creating a regulatory nightmare.
Collin De La Bruere ’13 is a Contributing Writer