Assessing the impact of the Dodd-Frank Act four years later

Chairman Hensarling, Ranking Member Waters, and distinguished members of the Committee, thank you for convening today’s hearing, “Assessing the Impact of the Dodd-Frank Act Four Years Later” and thank you for inviting me to testify. I am a resident scholar at the American Enterprise Institute, but this testimony represents my personal views. My research is focused on banking, regulation, and financial stability. I have years of experience working on banking and financial policy as a senior economist at the Federal Reserve Board, as a Deputy Director at the IMF and most recently, for almost ten years, as Director of the FDIC Center of Financial Research where I served a three-year term as chairman of the Research Task Force of the Basel Committee on Bank Supervision. It is an honor for me to be able to testify before the subcommittee today.

The theme of my testimony is that the Dodd-Frank Act has failed to achieve its stated goals of ending too-big-too-fail and reducing the fragility of the U.S. financial system. Instead, the balance of accumulating evidence suggests that Dodd-Frank has reinforced investor’s perceptions that the largest financial institutions enjoy an extended government safety net. Rather than ending too-big-to-fail, Dodd-Frank’s provisions create new uncertainties around the resolution process for large financial institutions.

Dodd-Frank’s mandatory enhanced supervision and prudential standards for the largest institutions discourage investor due diligence and monitoring since government regulators are now intimately involved in the management of the largest designated financial institutions. Dodd-Frank’s intrusive rules and supervision impose undue regulatory burdens that are constraining economic growth without providing any clear measureable stability benefits.  Dodd-Frank’s enhanced prudential supervision and regulation do not provide a guarantee against a large institution failure nor can they prevent a future financial crisis since the exercise of most of these new powers are based on regulatory judgment alone. There is no proven economic science to guide the identification of “systemic risk” let alone pin-point regulations that can mitigate it.

Ironically, Dodd-Frank’s heightened expectations of a government’s commitment to remove the possibility of a future financial crisis may increase the probability that such a crisis will occur and require government support for the largest financial institutions that have been identified as too-big-to-fail.  The future under Dodd-Frank is foreshadowed by the famous words of the Irish philosopher Edmund Burke, who said, "Those who don't know history are destined to repeat it." Prior to the last financial crisis, many nations had in place institutions and practices similar to Dodd-Frank’s Financial Stability Oversight Council and macroeconomic stress tests that were designed to identify and prevent financial instability, and yet none did.

A guide to the remainder of my testimony follows. Section I provides empirical evidence based on large bank funding costs that Dodd-Frank did not end too-big-to-fail.  Section II discusses how the Dodd-Frank combination of vague policy goals and unchecked grants of new regulatory powers creates a bias for over-regulation of the financial sector that reinforces investor perceptions that the largest institutions are too-big-to-fail.  Section III discusses the trade-off between financial safety and soundness regulation and economic growth and how over-regulation of financial institutions reduces economic growth. Section IV discusses Title II Orderly Resolution Powers and the FDIC Single Point of Entry Resolution Strategy.

A high-level summary of my testimony follows:
•    Four years after its passage, there is no evidence that the Dodd-Frank Act has ended too-big-to-fail, indeed Dodd-Frank has probably reinforced investor expectations that the largest financial institutions benefit from government safety net protections that are not available to smaller institutions.
•    Dodd-Frank grants financial regulators, especially the Board of Governors, the Financial Stability Oversight Council and the FDIC, extensive new powers with few constraints while assigning them the duty to ensure financial stability, a concept that is never defined in the legislation. The absence of objective guidelines and restricted judicial and Congressional review allows regulators to exercise their new powers based on their judgment alone.
•    In the current environment, the mix of ill-defined duty and unconstrained regulatory power is a recipe for over-regulation and slower economic growth.
•    A Dodd-Frank Title II resolution using the FDIC’s single point of entry (SPOE) strategy does not fix the too-big-to-fail problem. In order to keep subsidiaries open and operating to avoid creating financial instability, the SPOE extends government guarantees to subsidiaries. In many cases, these guarantees will be far larger than those that would be provided under a bankruptcy proceeding and Federal Deposit Insurance bank resolution.
•    The Title II and SPOE create new uncertainty regarding which investors will be forced to bear losses when a bank holding company fails.  This increased uncertainty will undermine investor confidence and financial stability and could create a political crisis. Title II creates a conflict of interest between contributors to the deposit insurance fund and contributors to the orderly liquidation fund. Title II and SPOE alter investor property rights without prior notice, compensation, or due process and with little scope for judicial protection. 
•    Dodd-Frank does not amend deposit insurance laws to require the FDIC to break-up large banks in a resolution and prohibit whole bank purchase resolutions. Such a change is needed to stop the FDIC resolution process from creating new too-big-to-fail institutions.

Assessing the impact of the Dodd-Frank Act four years later by American Enterprise Institute

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Paul H.
Kupiec

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