Skip to content

The US banking sector and the impact of the Dodd-Frank Act

April 24, 2013

As the eurozone tries to pull itself together after yet another banking crisis – this time, in Cyprus – the United States’ financial sector appears to have almost fully recovered from the Great Recession and seems to be (at least on the surface) in much better shape than Europe’s. But questions remain about the real resilience of American banks in the long run and about their continued exposure to excessive risk, especially in the wake of JPMorgan’s “London Whale” scandal. Therefore, the debate surrounding issues such as lasting systemic threats to this industry and the US economy as a whole, the size of financial firms, and “too big to fail” (TBTF) – as well as the Dodd-Frank Act, the Wall Street Reform and Consumer Protection Act that Congress passed in 2010 in the hope of strengthening financial regulations and never again allowing for a repeat of the recent crisis – has recently picked up again. And with a very surprising line up of allies and counter-allies.

In March, the Federal Reserve ran its annual stress test of America’s largest financial institutions. “The results […] continue to reflect improvement in banks’ condition,” said Fed Chairman Ben Bernanke in an April 8th speech. Of the 18 largest banks that underwent testing, all but one were found to have strengthened their defenses against the possibility of a new financial crash. “Projected aggregate loan losses under this year’s most stressful scenario (the so-called severely adverse scenario) were 7% lower than the comparable figure last year, in part because the riskiness of banks’ portfolios continues to decline,” commented Bernanke. In addition, those same 18 firms have roughly doubled their capital levels, “from 5.6% of risk-weighted assets at the end of 2008 to 11.3% at the end of 2012.” This not only puts many of them already in line with the international standards set forth by the Basel III agreement but also enables them to better absorb losses.

At the same time, however, the implementation of Dodd-Frank – the law which has tried to rein it all in – is far behind schedule. What’s more, in the ongoing process of rule-making, some of its key and more controversial provisions are being watered down due to intense industry lobbying. For example the Volcker Rule, which was originally intended to prevent banks from engaging in speculative trading but, experts say, has been spelled out so vaguely that it lost its bite. As a result, many people are now starting to doubt whether, even when fully enacted, Dodd-Frank will really shield US banks from the worst systemic risks, and taxpayers from having to bail them out in case they fail.

According to Saule Omarova, Assistant Professor of Law at the University of North Carolina, the effort by Dodd-Frank to make the financial system more transparent and thus safer is commendable and necessary, but it might fall short of the law’s lofty goal. “For example, I don’t think that merely requiring standardization, central clearing, and exchange-trading of derivatives solves the fundamental problem posed by these complex and highly malleable products, which often serve to synthesize, amplify, and hide risk,” she says.

As for TBTF, Dodd-Frank establishes the so-called “Orderly Liquidation Authority”, which would manage the receivership process for financial institutions that are large enough to pose a systemic threat. This, according to supporters of the act, should eliminate any future need for taxpayers-funded bailouts. “That assumption is, in and of itself, highly questionable” says Omarova, who is a former Special Advisor for Regulatory Policy to the Under Secretary for Domestic Finance at the Department of the Treasury. “If there is a situation in which, for example, JPMorgan is about to fail, one can imagine the pressure on policymakers not to let that happen, for many obvious reasons. And things would likely unfold in a familiar fashion. They would get together and try to find somebody to buy up bits and pieces of the company, and the government would have to subsidize the rescue.”

Doubts about the Dodd-Frank Act are so widespread – even among Democrats who pushed through the law – that there are currently two proposals under consideration in Congress that revisit the TBTF question again. Senator Bernie Sanders, a leftist independent from Vermont, and Representative Brad Sherman, a democrat from California, recently unveiled a plan to have the Department of the Treasury break up financial institutions that present a systemic threat. Democratic Senator from Ohio Sherrod Brown and Republican Senator David Vitter from Louisiana, in the meantime, are working on a different legislation that would greatly increase capital requirements for the biggest banks, so that they are better cushioned against losses and simultaneously disincentivized from making riskier bets.

Neither bill has much of a chance to win Congress’s approval but the simple fact of their existence signals growing skepticism about the ability of the current law to fix the system in an enduring way.

The act also continues to be a sticking point for conservatives, who were opposed to it from the get go.  “Dodd-Frank was based on a wrong diagnosis of the financial crisis and thus missed everything of importance,” says Peter Wallison, a co-director of the program on financial policy studies at the American Enterprise Institute in Washington, D.C. “Because it conceived the crisis as the result of insufficient regulation, it imposed new and costly regulation on the financial system, slowing the growth of the US economy.” In his view, the great recession was the product of the federal government’s housing policies, which encouraged excessive borrowing by households that would not be able to repay their debt.

Wallison also believes that Dodd-Frank did nothing to address TBTF, which he views as a problem because it benefits larger institutions over smaller competitors in terms of access to funding. “The advantage of TBTF firms is conferred by the market’s belief that the government will rescue any of the large banks if they are failing,” he says. “The Dodd-Frank Act makes this worse by empowering the government to designate non-bank firms as systemically significant, thus creating TBTF firms in other industries such as insurance.”

Surprisingly, Wall Street and the administration of President Barack Obama are now left to defend Dodd-Frank together.

For leaders of the financial industry, who are already trying to gut the law, this is a way to fend off even more regulation. For the White House, instead, this is just a matter of defending its own record, since doing otherwise would be akin to admitting failure. Therefore, officials take the long view and insist that, once the law is fully in place, it will solve once and for all the issue of bailouts. In an interview with Rolling Stone Magazine published in November of last year, President Obama said: “The story of Dodd-Frank is not yet complete, because the rules are still being developed. Dodd-Frank provided a platform to make sure that we end some of the most egregious practices and prevent another taxpayer-funded bailout […] So there’s a lot of good work that will be done around Dodd-Frank.”

Mimicking the administration’s official position, Scott Talbott, Senior Vice President for Public Policy at The Financial Services Roundtable, a lobbying group for the banking industry, told the newspaper The Hill last week: “We believe that Dodd-Frank, once fully implemented, addresses the issue of ‘too big to fail.’ ”

As they say, politics make strange bedfellows. In the meantime, the future of Dodd-Frank hangs in the balance together with that of the US’s financial sector.

Originally published in Aspenia Online of the Aspen Institute Italia

No comments yet

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: