“The Financial CHOICE Act espouses some principles that we heartily endorse. Chief among them is that the more well-capitalized institutions are, the less of a threat they pose to financial stability. And we endorse removing many inefficient parts of Dodd-Frank. But at the end of the day, the CHOICE Act is fatally flawed by a failure to recognize systemic risk and to understand the dangers that it poses for the financial system—and thus for the healthy functioning of the U.S. economy. Because of this failure, the CHOICE Act represents a step backward in the establishment of a prudential regulatory system that would ensure a safer and better functioning financial sector for the U.S. economy.” Conclusions to Regulating Wall Street: CHOICE Act vs. Dodd-Frank
With the shift in power in Washington, among other things, the people newly in charge are taking aim at financial sector regulation. High on their agenda is repeal of much of the Dodd-Frank Act of 2010, the most far-reaching financial regulatory reform since the 1930s. The prime objective of Dodd-Frank is to prevent a wholesale collapse of financial intermediation and the widespread damage that comes with it. That is, the new regulatory framework seeks to reduce systemic risk, by which we mean that it lowers the likelihood that the financial system will become undercapitalized and vulnerable in a manner that threatens the economy as a whole.
The Financial CHOICE Act proposed last year by the House Financial Services Committee is the most prominent proposal to ease various regulatory burdens imposed by Dodd-Frank. We previously discussed the CHOICE Act from the perspective of small banks that pose no systemic risk. Our conclusion then and now is that, while there is good reason to ease the regulatory burden on what are called community financial institutions―banks with assets less than $10 billion that constitute 98 percent of FDIC-insured banks―this objective provides no rationale for the CHOICE Act’s downgrading of scrutiny on the largest intermediaries, such as the 37 institutions that meet the Dodd-Frank systemic threshold of $50 billion in assets (see chart).
Cumulative Asset Share of U.S. Financial Holding Companies Ranked by Asset Size, September 30, 2016
But the CHOICE Act is complex, containing provisions that would alter many aspects of Dodd-Frank, including capital requirements, stress tests, resolution mechanisms, and more. This month, more than a dozen faculty of the NYU Stern School of Business (including one of us) and the NYU School of Law published a comprehensive study contrasting the differences between the CHOICE Act and Dodd-Frank. Regulating Wall Street: CHOICE Act vs. Dodd-Frank considers the impact both on financial safety and on efficiency. In some cases, the CHOICE Act would slash inefficient regulation in a manner that would not foster systemic risk. The poster child is the proposed repeal of the Volcker Rule, the implementation of which has generated complex rules that seem to have little connection to systemic risk but induce burdensome trade-by-trade compliance costs.
At the same time, the book highlights the key flaw of the CHOICE Act—the failure to address systemic risk properly. As Thomas Cooley notes in the volume's introduction, the CHOICE Act relies on false premises: (1) that intermediaries are systemic “solely because of the implicit government guarantees associated with designating them” as systemically important financial intermediaries (SIFIs) under the rules of Dodd-Frank; and (2) that “eliminating SIFI designation means that the government will not bail out creditors even if that would induce another economic collapse.”
That these premises are false is evident from the experience of the 2007-2009 crisis, when there was no Dodd-Frank Act and there were no designated SIFIs. This did not prevent the financial distress that plagued poorly capitalized banks, including the largest ones that received government bailouts. Moreover, as Ralph Koijen and Matthew Richardson emphasize in their discussion of SIFI designation, all five large stand-alone investment banks (Bear Stearns, Goldman Sachs, Lehman, Merrill Lynch, and Morgan Stanley) experienced bank-like runs during the crisis and some became insolvent. If large banks can be systemic, surely nonbanks conducting de facto banking activities can, too. The distinction between the two is solely one of legal form, not economic function.
Second, the Troubled Asset Relief Program (TARP), which Congress enacted into law following Lehman’s September 2008 failure, illustrates the meaninglessness of the CHOICE Act’s promise to forbid future government bailouts. Short of a constitutional amendment, it is not feasible for today’s Congress to prevent any future Congress from funding a bailout. The only way to limit the persistent moral hazard arising from the prospect of future government bailouts is to establish a strong and credible regulatory framework that constrains the risk-taking of the largest, most complex, and most interconnected financial intermediaries.
Regulating Wall Street highlights a number of ways by which the CHOICE Act would make the financial system less safe than it is with the current (however inefficient) implementation of Dodd-Frank. The most important of these are by: (1) exempting the largest banks from strict prudential oversight if they satisfy a 10 percent capital leverage standard, providing what is called an “off-ramp”; (2) eliminating even temporary public funding for the resolution of large, systemically important institutions; and (3) eliminating the designation by the Financial Stability Oversight Council of select nonbanks as SIFIs and of systemic payments, clearing and settlement (PCS) firms as financial market utilities (FMUs). Each of these exacerbates the too-big-to-fail problem (see our earlier post).
Starting with bank capital, we strongly believe that increasing the share of assets that are funded by equity is the most effective means of reducing systemic risk in the banking system. So, the CHOICE Act’s push for a higher capital standard seems like a positive move. Unfortunately, by allowing the largest banks the option of reduced regulatory scrutiny in exchange for higher capital, and by failing to anticipate regulatory circumvention efforts by banks and nonbanks, the CHOICE Act’s off-ramp increases the likelihood of another crisis. The Stern authors argue that limiting systemic risk among the largest banks requires that they remain subject to Dodd-Frank-mandated stress tests and living wills, even if other regulatory burdens can be safely trimmed.
Philipp Schnabl’s essay on Bank Capital Regulation and the Off-Ramp makes the case for stress tests on at least two grounds. First, since it will always be difficult to measure leverage arising from off-balance sheet exposures and the use of derivatives, stress tests are an essential tool if we are to certify that a bank’s capital meets the established standard (see our earlier post). Second, the key to managing systemic risk is to ensure institutions retain sufficient capital when the financial system as a whole is experiencing distress. Stress tests are the only policy tools for measuring expected leverage in that distressed state. In this context, we believe that the CHOICE Act’s threshold of a 10 percent leverage ratio in the good state of the world is below the level of capital needed to ensure that banks are safe (see, for example, our earlier post on the Minneapolis Plan to End Too Big to Fail).
Turning to resolution, in Resolution Authority Redux, Barry Adler and Thomas Philippon make the argument both for living wills to guide the orderly resolution of large, systemically important institutions and for public funding in the resolution process. Insofar as possible, living wills should be designed in a manner that triggers automatic re-capitalization, converting the most junior debt liabilities as needed to restore a healthy equity cushion (see our earlier post). On funding, Adler and Philippon note that debtor-in-possession (DIP) finance would be needed under a new bankruptcy regime, which the CHOICE Act proposes as a replacement for Dodd-Frank’s Orderly Liquidation Authority (OLA). Indeed, the scale of funding required for an orderly resolution of even one SIFI (let alone several at once), combined with the scarcity of private credit, means that government credit will likely be the only viable source of such financing in a crisis. Because the alternative of letting the financial system collapse lacks credibility, this means that the CHOICE Act’s exclusion of public funding in resolution would render the framework ineffective in limiting systemic risk-taking today.
Finally, there is the treatment of critical financial infrastructure firms. In Don’t Forget the Plumbing, Bruce Tuckman highlights the inherently systemic nature of payments, clearance and settlement (PCS) firms. Eight of these―including The Clearing House Interbank Payments System (CHIPS) that clears over $1.5 trillion in transactions per day, The CLS Bank International that clears more than $3 trillion in daily foreign exchange transactions, and the Depository Trust Company, which processes an average of $6 trillion worth of securities per day―currently are designated as FMUs under Dodd-Frank. By eliminating FMU designation, the CHOICE Act would mean that these firms would neither be subject to Fed oversight nor would they retain access to Fed lending in a period of illiquidity. Considering their enormous scale and essential function, the failure of any one of these could bring down the financial system—designated or not. Given the likelihood of government intervention in the event of a failing PCS firm, Tuckman “suggests a resolution protocol in the form of nationalization” supported by public funding. To forestall liquidity crises (and to limit barriers to entry in the PCS industry), he also calls for general access of PCS firms to Fed lending (in return for Fed oversight).
In addition to the essays on systemic risk described here, a second set of essays in Regulating Wall Street: CHOICE Act vs. Dodd-Frank discusses the CHOICE Act’s efforts to limit regulatory and policy discretion that are not related to systemic risk management. The third and final set of essays in the book focuses on key problems—including the government-sponsored enterprises, the costly and ineffective complexity of the regulatory framework, and the systemic risks arising from de facto banking activities—that neither Dodd-Frank nor the CHOICE Act properly address. The authors conclude by noting that there is still plenty of time to address the proposed CHOICE Act’s flaws.
We are left hopeful that the Act’s drafters will benefit from the book’s suggestions on how to preserve Dodd-Frank’s progress on systemic risk management, while providing effective regulatory relief. Here we have highlighted stress tests, resolution funding, and financial market infrastructure as issues of systemic importance, while distinguishing the Volcker Rule as an instance of regulatory excess. If legislators focus on reducing systemic risk, there are clear ways to modify and refine Dodd-Frank that will make the financial system both safer and more efficient.