Necessary Reform: The Dodd-Frank Act
2008: a year that will live on in economic infamy. During a short period of time, the United States witnessed a total GDP loss of over $650 billion, costing American workers over 5.5 million jobs.
Analysts have disagreed over the exact cause of the 2008 financial crisis. Indeed, many economists contend that subprime mortgages, many of which could never be repaid by the borrowers, doomed the economy.
Others have argued that deregulation that resulted from the repeal of the 1933 Glass-Steagall Act resulted in banks unwisely “gambling” with consumer money on risky security investments. Finally, others have written that the advent of poor regulation, not deregulation, sparked the crisis as a result of banks entrusting the government to issue bailouts, thus decreasing risk and creating moral hazard.
While the exact cause of the 2008 crisis is disputed, there has been a common theme among analysts that, regardless of policy, centralized financial institutions played a large role in the meltdown.
Many scholars have indeed contended that extensive centralization from corporate firms has hindered recovery efforts. In fact, research has shown that corporations that had largely institutional ownership or independent boards had a higher loss of return to shareholders when facing financial crisis during 2008. Most significantly, as both conservatives and liberals took strong stances against, “too big to fail,” political capital had already begun to accumulate behind new legislation for banking regulation.
In response, the Obama administration passed the 2010 Dodd-Frank Reform Act. The act had two primary goals: (1) limit the risks banks and other financial institutions could take, and (2) mitigate the potential damage of a similar incident in the future.
The act works in several ways. Functionally, it required banks to maintain capital reserves of investments, while creating liquidation procedures if regulators believed certain assets had a high probability of default.
Another regulation, known as the Volcker Rule, created large limitations on speculative investment options for banks, as well as creating the Financial Stability Oversight Council to implement regulations. Simply put, in the case of insolvency, the government attempted to create regulations to prevent a panic on the open market.
However, the act had several large deficiencies. First, and most obviously, the act had several extremely limiting, or outright irrelevant, regulations. For instance, Section 1502 of the act mandates companies report “conflict minerals,” and the Security and Exchange Commission under President Obama used its legal authority in the act to regulate trade with ‘war torn countries,’ especially Central Africa.
On net, the total compliance costs for central Africa alone have cost U.S. companies over $16 billion in lost revenues; worse, almost all of these investment opportunities have been taken by Chinese companies, further diminishing the competitiveness of U.S. companies. Thus, investment opportunities such as the Democratic Republic of Congo, a country which has over $24 trillion in mineral resources, remains untapped by US companies.
Secondly, the regulations that sought to fight the “too big to fail” mentality have only strengthened it. Recently published empirical evidence has indeed confirmed this, showing that in the wake of the Dodd Frank Act, small community banks have lost almost 20% of their banking assets, while the top 5 firms remained untouched.
These banks, facing the massive burden of compliance costs imposed by regulations, have suffered while larger firms, who have extensive legal teams, continue to profit. Worse, these community banks provide over ½ of the loans provided to small business and over 2/3rds of the loans provided to rural or agricultural practices. In essence, the Dodd Frank Act has created a spaghetti-like web of complicated legal procedures that have made the banking industry virtually impossible to access for all but a select few.
Worst yet, there is no evidence that the Dodd Frank Act will even protect the economy. An article published in 2011 by the Chicago School of Law explains that the Dodd Frank Act would act very similarly to the Maginot Line; while it may prevent predatory lending and subprime lending, it does nothing to specifically address speculation and credit, problems that continue to be exploited by the financial elite.
Indeed, it is important to note that the act still provides measures for bailouts, and preserves the abilities of corporate CEOs to take unilateral actions that small firms cannot (such as structuring debt with limited capital backing).
In short, the Dodd Frank Act acts as a both a suppressant to competitive behavior, and an accelerant of risky financial investments -- after all, why not invest in a security promising a 12% return if taxpayers are footing the bill?
Luckily, on June 8th, the Republican-controlled House passed the Financial Choice Act, effectively rolling back many of the harmful regulations of the Dodd Frank Act. While the act will likely face strong Democrat opposition in the senate, it provides a hopeful measure for the future of financial institutions in this country.