Politics / Regulation

House GOP’s Dodd-Frank Fix: A Market-Based Solution

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Via Ramy Majouji, Flickr

When Wisconsin Congressman Paul Ryan started as Speaker of the House last October, he promised to outline a Republican vision on policies for the 2016 election. Last week, chairman of the House Financial Services Committee, Rep. Jeb Hensarling (R-TX), began that process by outlining a bill designed to replace the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. With eight months left in President Obama’s presidency, this bill stands no chance of passing this year, but will serve as the starting point for GOP reform to Dodd-Frank if Donald Trump is elected president. Rep. Hensarling did not consult Donald Trump, who has said his plan “will be close to dismantling of Dodd-Frank,” when crafting the legislation. Analyzing Rep. Hensarling’s plan sheds insight into the likely changes a Republican controlled government would make to the U.S. financial sector: market-oriented solutions incentivizing banks to regulate themselves.

At the forefront of the bill is a plan to scale back the authority of the Financial Stability Oversight Committee’s (FSOC) ability to label firms as “systematically important financial institutions (SIFI).” The SIFI designation means the Federal Reserve has determined the collapse of a firm would pose a serious risk to the economy, subjecting the firm to a greater number of regulations and oversights. Some of the possible regulations include being subject to increased capital requirements, increased reporting, and a requirement to produce a “living will” outlining how the firm would operate in the event of bankruptcy. Firms must hire extra employees, invest in new technology, and set aside more capital, at significant cost to firms and their customers.

MetLife Inc. already successfully challenged the FSOC’s power to label firms as SIFI and shed its own designation in March of this year. GE petitioned to be released from their designation the next day, stating that they have ended much of their financial services work and therefore do not pose a serious threat to the financial system. Even now, there is much speculation that Prudential and AIG will try to shed their designations. If the House GOP’s bill were to pass, the FSOC would lose its authority to designate firms as SIFIs.

The proposal also frees banks from the Volcker Rule, a rule the American Action Forum has discussed in depth. The focal point of the Volcker Rule is to prohibit banks from proprietary trading, or trading for the banks profits rather than for their customers. Experts agree that proprietary trading did not cause the financial crisis, so overregulating proprietary trading leads to a reduction in liquidity for the bank by eliminating an avenue for banks to “make market,” without tackling the causes of the financial crisis. Furthermore, a lack of bank liquidity decreases the competitiveness of the bank, driving up costs for customers. The GOP proposal includes changes to the Consumer Financial Protection Bureau (CFPB), limiting the power of the director by creating a five-member agency and limiting their oversight in regulations on certain industries (payday lending, debt collection, etc.).

While most financial institutions back many of the House GOP’s ideas, some ideas draw skepticism. Many banks have already adjusted to Dodd-Frank’s new regulations and written off the costs. Changing how they operate now would require additional costly changes.

One proposal many banks are skeptical of is the new capital standards requirement. Under the House GOP plan, banks can avoid tougher regulatory oversight by meeting certain capital requirements, such as maintaining a 10% leverage ratio. This means they maintain a minimum of 10% of their capital assets in reserves at any one time. Banks have said the 10% leverage ratio is too high. By limiting lending and requiring large banks to raise several hundred billion dollars to meet the requirement, they say they are at a competitive disadvantage internationally. Most community banks, however, already meet the 10% ratio and therefore benefit over the nation’s largest banks.

The House GOP plan gets many things right. As seen in the case of MetLife, the FSOC’s process for designating companies as SIFI is overbearing and lacks transparency. Repealing the FSOC is necessary to relinquish companies, and their customers, from unnecessary regulations and costs. Replacing the single, unaccountable director of the CFPB with a five-member agency, subject to Congressional oversight, is necessary to make sure the financial sector is properly policed. The House GOP understands that incentives affect behavior. Raising capital standard requirements to 10% to free entities of some of Dodd-Frank’s regulations and increasing fines in return for lowered regulations are practical, market-oriented solutions that will incentivize companies to regulate themselves.

The plan, however, misses two major points. The first being, repealing the Volcker Rule. This is necessary, but so is replacing it, as the American Action Forum outlines. Former Fed Chairman Volcker had another plan that would merge the SEC and the U.S. Commodity Futures Trading Commission (CFTC) into one agency and get rid of the Office of the Comptroller of the Currency (OCC). The SEC and the CFTC serve many of the same regulatory purposes, so merging them would reduce paperwork hours and compliance costs for companies they oversee. The OCC charters, regulates, and supervises the national banks. By adding a bank supervisor to the Federal Deposit Insurance Corporation (FDIC), the OCC’s functions could be maintained, while again doing away with two government entities serving the same roles.

The second point Rep. Hensarling’s plan misses is GSE reform. One of the biggest issues with Dodd-Frank is that it did nothing to reform the GSEs (Fannie Mae and Freddie Mac), despite the largest U.S. taxpayer bailout in history, $187 billion. GSE reform is very complex, so it is understandable why Rep. Hensarling’s plan does not mention it. But if the aim is to prevent another financial crisis, it should.

By focusing on market-oriented incentives to keep the industry in check, rather than regulations that tell it what it can and cannot do, the House GOP has crafted a plan that will maintain financial stability, while allowing it to grow free from unnecessary burdens. Donald Trump is set to release his Dodd-Frank reform plan soon. Comparing it with Rep. Hensarling’s plan will be necessary to prepare for what a Republican victory in November would mean for Wall Street.

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