In Defense of Dodd-Frank

It’s been nearly a decade since we first felt effects of the Great Recession. While the recession officially ended, its consequences still affect us. Some are beneficial, others (like sluggish growth and the number of people leaving the labor market) not so much. One of the better side effects of the 2007-2008 crash, however, is likely to disappear rather soon: the Dodd-Frank act. The newly inaugurated White House is eager to scrap that set of financial regulations.

My goal with this post is to present a very simple explanation of what Dodd-Frank is, why some people want it gone, and why we should fight to keep it and strengthen it. Hopefully, this accessible explanation will motivate more people to join the fight. Maybe then we can have our voices heard. With this objective in mind, I am aware that some details will not be pursued to their full extent, but the overall message should still be whole.

Illustration: Heske van Doornen

Let me start with a very simplified analogy. Think of the financial system as a system of highways. In a modern highway, there are usually a few lanes on each side, separated by a median. There are many regulations put in place to make sure that the people zooming past each other inside two tons of metal–all the while sitting inches away from gallons of gasoline–do it safely. In this analogy, your average American with their savings, retirement account, mortgage, student debt and credit cards is driving north on the “commercial” lanes in their Peel P-50 (click the link, it will help you understand where I am going with this). Besides them are other entities such as big banks, hedge funds, insurance companies and the like. Those are heavy 18-wheelers and tanker trucks, so the massive gusts of wind that they create will shake smaller cars as they pass by. Of course, whenever a P-50 gets into a crash (like when a head of household goes bankrupt) it is tragic, but it does little to the overall flow of traffic. However, when one of those big vehicles crashes, it often leads to a chain reaction of other accidents, which affects all other drivers and overall makes everyone’s day a lot worse.  

After the great crash of 1929 (the financial crash, I’m unaware of any major vehicular crashes from back then), a set of fairly stiff regulations were designed to keep the drivers of that industry–namely the banks and other financial institutions–from getting in other accidents of similar magnitude. Those regulations were known as the Glass-Steagall Act of 1933, enacted as an answer to the failure of almost 5,000 banks. The legislation was put in place to strengthen the public’s opinion towards the financial sector, to curb the use of bank credit speculation, and to direct credit towards more “real economy” uses. In our analogy, Glass-Steagall introduced a number of norms to the ‘financial highway’. Most notably, it created a solid median between the financial and the commercial banking lanes. Now, commercial banks could not use their clients’ funds to engage in risky investments in the financial markets. In our analogy, it means that before Glass-Steagall those big trucks were free to go across the road to the “wrong way” whenever they felt like doing so would be beneficial for them. In addition, Glass-Steagall also created the FDIC, which insures bank deposits; think of it as the weight-per-axis limitations that help preserve the roads from the damage caused by overloaded trucks.

Fast forward to the Clinton presidency, 1999 to be exact. By then, the broad belief that separation between financial and commercial banking was necessary had lost force, even though it had kept the American economy away from any significantly serious recession/depression for over 70 years. That year the barrier between the financial and commercial lanes was brought down. Now, banks and other financial players were free to drive on whatever side of the highway they wanted; banks (and others) are now able to use their clients savings and retirements accounts to buy and sell toxic financial assets such as CDOs. As a result, they were able to take bigger risks, which brought–in many cases–good rewards. This is the era of leveraging, or what Minsky called “Money Manager Capitalism.” To some, it was clear that such an environment would eventually lead to a big crash; a few smaller ones serving as a warning. Indeed, with 2007 came the worst financial and economic ‘accident’ in almost 80 years.

Financial regulations are naturally reactionary. As Minsky stated, the economy is inherently unstable, and in good part that is due to the financial sector’s insatiable thirst for financial innovation. Regulators need to remain attentive to the markets and introduce rules to curb too-risky behaviors as they surface. This is especially true in the days and weeks following a crisis. Once the dust has settled we can look into the causes for the downturn, and put in place measures that are supposed to keep it from happening again, not unlike the way traffic regulations are designed. As such, the Dodd-Frank Act was drafted to put a stop to some of the recklessness that drove us to the Great Recession.

In short, Dodd-Frank ended Too Big to Fail Bailouts, created a council that identifies and addresses systemic risks within the industry’s most complex members, targeted loopholes that allowed for abusive financial practices to go unnoticed, and gave shareholders a say on executive pay. It aims to increase transparency and ethical behavior within the financial sector, both of which are good things.

In no way is the Act perfect. Some, like me, would have advocated for much stiffer regulatory practices like rebuilding the division between financial and commercial banks, or taking a more definitive approach to dissolving Too-Big-To-Fail institutions. Therefore, during its somewhat short existence, Dodd-Frank has received much criticism. While some of those critiques were fair and well founded, the loudest critics were the ones coming at a wrong angle. As it happens the loudest critics now have the opportunity to scrap those safeguarding regulations altogether.

The most common criticism of the Act (and the main reason the administration has given to overrule it) is that it has made it harder for people and businesses to borrow. That criticism is untrue. For example, Fed Chair Janet Yellen showed in her latest address to the senate that “lending has expanded overall by the banking system, and also to small businesses.” A survey from the National Federation of Independent Businesses, cited by Yellen, shows that only 2 percent of businesses that responded cited access to capital as a great obstacle to their activities. Furthermore, to claim that Dodd-Frank has a macro impact on lending is, at least, sketchy. As Yves Smith puts it:

“For starters, big corporations use bank loans only for limited purposes, such as revolving lines of credit (which banks hate to give but have to for relationship reasons because they aren’t profitable) and acquisition finance for highly leveraged transactions (and the robust multiples being paid for private equity transactions says there is no shortage of that). Banks lay off nearly all of the principal value of these loans in syndications or via packaging them in collateralized loan obligation. They are facing increased competition from the private equity firm’s own credit funds, which have become a major force in their own right. Otherwise, big companies rely on commercial paper and the bond markets for borrowing. And with rates so low and investors desperate for yield, many have been borrowing, for sure….but not to invest, but to a large degree to buy back their own stock.”

In fact, the amount of cash held by American corporations reached an all-time high in 2013. This shows that companies are sitting in liquidity without investing in the real economy. The hoarding of liquidity could even be considered an actual fail of Dodd-Frank; unlike the stiffer Glass-Steagall act it did not focus on pushing investment into the production of real goods and services.

The publicized reasoning behind repealing Dodd-Frank is untrue, so what is the motivation for lobbying against the regulations? In my opinion, there are two main arguments. The less malicious one is that there is still people out there who believe than an unregulated, free-for-all financial sector is effective, benevolent, and will serve the greater good. It is almost a dogmatic position based mostly on circular logic, and unrealistic economics modeling (which often does not even take the financial sector into account!), and lack of supporting evidence. It should be put aside. The second argument seems to be popular among lobbyists and government officials: reducing regulations will allow (at least in the short run) for immense profits.

Without Dodd-Frank, Wall Street will most likely revert to the risky and reckless practices that led to the Great Recession. The repeal of the act would, in Minskian terms, act as a catapult launching us towards the Ponzi state of finance, in which risky borrowing and lending end in a financial crisis. Doomsday predictions aside, repealing Dodd-Frank would hurt the common folk like you and I. For example, the Fiduciary Rule is likely to also be erased, and it requires that investment advisers put their clients’ interests above their own. This puts people’s retirement savings at great risk. If money managers do not have to act in their clients’ best interest, they will make decisions that allow them to maximize their commission even if it means losing money for their clients. Additionally, to some extent, the repeal would kill thousands of jobs across the nation; because of Dodd-Frank, financial institutions had to create and staff entire departments focused on quality assurance and compliance, without the rules these employees are not longer needed. Finally, without the rules, banks can go right back to targeting the most vulnerable and financially illiterate among us, offering them loans, mortgages, and other predatory instruments they cannot possibly afford; it would be disastrous.

Reverting back to our simplified analogy. Since the repeal of the Glass-Steagall Act, the highways of the financial systems do not have a median, separating investment traffic from going the ‘wrong way’ into the commercial lanes. Further repealing rules such as the Dodd-Frank Act, without substituting with a set of better regulations, is like removing the usage of turning signals, the requirement for turning the lights on at night, and speed limits – all the while releasing the Bull from Wall Street right in the middle of heavy traffic. Accidents will happen, and in the case of our financial highway it does not matter if we are inside the vehicles involved, we are all going to become casualties of the crash.