President-elect Donald Trump won the election in part because he promised both stronger economic growth and a reduction in the size and complexity of the federal government. Voters chose growth over redistribution, and the people said no to the regulatory state.
Voters also selected a Republican Congress. So, the pieces are in place to deliver on the promises of the campaign. A good place to start on the path to a stronger economy and fewer regulatory burdens is the financial sector. The U.S. financial sector accounts for over 20% of value added to GDP. It is the largest part of the economy. Finance dwarfs the second-largest sector, business and professional services, which accounts for about 13% of value added to the economy.
Unfortunately, the financial sector, which includes banking, lending, and real estate, is shackled by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The act is over 2,300 pages long and resulted in the creation of over 27,000 new rules and regulations.
Dodd-Frank was passed into law in 2010 as a consequence of the great financial crisis of 2007-2009. Congress passed this enormous piece of legislation, which touches and regulates all aspects of the financial sector, because Congress and many supposed experts blamed the financial crisis on the banking sector and excessive leverage in the subprime mortgage market.
Yes, the immediate catalyst of the financial crisis was the implosion of the subprime market. Too many mortgages were issued to homeowners with poor credit histories, and too many mortgages had inflated assets-to-mortgage ratios. The Federal Reserve Board lowered interest rates to below 2% to rescue the economy after 9/11. When the Federal Reserve started to normalize rates, many subprime borrowers could not make their mortgage payments. A cascade of bad mortgage loans hit the market.
But the true proximate cause of the financial crisis was excessive government interference in the home mortgage market. The Community Reinvestment Act directed mortgage lenders to write mortgages for lower-income households, especially minority borrowers. Credit checks were less stringent. Moreover, Fannie Mae and Freddie Mac, government-sponsored entities, started to purchase more subprime mortgages from mortgage issuers. That was a signal to banks to issue more subprime mortgages. An avalanche of subprime mortgage lending occurred. Government caused the financial crisis, not the banks.
But politicians and government don’t like to accept responsibility and take the blame for an economic crisis. So, Washington blamed the banks. And here we are. The largest sector of the economy is hobbled. It is only a slight exaggeration to assert that Dodd-Frank was a giant step toward nationalizing the country’s largest banks.
Thanks to this foolish law, banks are penalized if they get too big. That means economies of scale and network effects are denied to our largest financial institutions, which have the capital and talent to invest, innovate, and contribute to long-run productivity growth. Banks are required to make certain loans, for example to low-income communities, and penalized for making other loans that the government in power does not like. When Democrats are in power, banks are discouraged from making loans to fossil fuel energy companies. Energy prices are higher. What the Democratic Party cannot accomplish through legislation, it accomplishes through political arm-twisting.
The federal government should not be in the business of allocating capital. That is the job of the private sector, especially the banking industry. The Trump administration and the incoming Republican Congress should repeal Dodd-Frank and rewrite banking regulations. The repeal and restructure of financial regulations could be conducted as part of the budget reconciliation process, which requires only simple majority votes for approval.
The enactment of Dodd-Frank was the equivalent of throwing paint on a wall and seeing what stuck. But the legislation did nothing to address the fundamental cause of the financial crisis: government interference in the mortgage market. The incoming Congress should rid itself of Fannie Mae and Freddie Mac.
Today, the country faces a housing crisis: too few homes. The United States needs 3 million to 5 million new units of housing. Fannie Mae and Freddie Mac stimulate demand but accomplish nothing regarding supply. Solution? Let the private sector fix the housing shortage. The role of the federal government should be to provide incentives for local governments to reduce the hurdles for new housing.
The Volcker Rule, no proprietary trading, of Dodd-Frank is unnecessary and bad policy. The country’s largest banks should be encouraged to engage in proprietary trading to facilitate trading with bank customers and to increase liquidity in financial markets. Greater liquidity and transparency improve pricing for financial assets, including U.S. Treasurys. Because of Dodd-Frank, the largest U.S. banks are overcapitalized.
Too much regulatory capital reduces bank lending across the economy. Capital stranded on bank balance sheets becomes unavailable for productive investment. The economy would grow faster if the biggest banks made more good loans and didn’t tie up so much capital by holding Treasurys. Any new banking legislation should mandate lower capital requirements. Free up capital.
Congress and policymakers fret too much about moral hazard, government bailouts of banks that go bust. The real risk in a bank failure is customer deposits. Reality and history say that the banking regulators will not allow any customer deposits at a federally regulated bank to be lost because of a bank failure. Look at what happened with Silicon Valley Bank, for example. Any new banking law should enshrine the principle that all customer deposits “are insured” into law. The moral hazard problem flowing from guaranteeing all deposits without encouraging excessive risk can be resolved by holding senior bank officers personally liable if their bank fails. Personal bankruptcy would be a powerful deterrent. Clawbacks of compensation over a five-year period would also be a significant deterrent to excessive risk-taking. These policies would also help earn public support for broader reform.
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Yet there’s another problem with Dodd-Frank — namely that the law also applies to the country’s smaller “Community Banks.” The evidence is clear that Dodd-Frank harms America’s local banks. Compliance costs are higher relative to smaller revenue streams. Smaller banks lose market share in making mortgage loans and in making commercial real estate loans. Repealing and replacing Dodd-Frank with reasonable capital requirements and federal deposit insurance for all depositors would level the playing field. Smaller banks would be able to compete with the country’s financial giants. Local communities would have access to more capital. Smaller communities would benefit. The nation would benefit.
Top line: Dodd-Frank is an anachronism. It did not achieve its goal of preventing bank runs. It did, however, increase the role of government in allocating capital, and the law created friction within the largest economic sector of the economy. Dodd-Frank reduces national welfare. Dodd-Frank is a bad law. Get government out of business.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note on the markets, politics, and society. He can be reached at [email protected]