The last time I was in India was October of 2008. The bankruptcy of Lehman Brothers had turned a housing-market brush fire into a global financial conflagration. The apparatus meant to prevent that sort of thing had utterly failed. On that visit I met the governor of the Reserve Bank of India, D. Subbarao, who asked me the question on everyone’s mind, not just in India: “Where were America’s regulators?”
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Well, they’re back, big time, emboldened and vastly more empowered by the most ambitious financial reform law to be enacted in the US since the 1930s. When the Wall Street Reform and Consumer Protection Act of 2010 (better known as Dodd-Frank, after the law’s chief legislators) was making its way through Congress last year, the national mood was vengeful: Legislators were determined to construct a regulatory fortress that ensured financiers could never again put the global economy at such risk and require so much national treasure to bail them out. Now, however, as regulators start to create the rules needed to enforce the 2,300-page law, anger is giving way to wariness. Americans are starting to realize that no one entirely understands exactly how the law will play out. As one waggish corporate law blog put it, “Let the unintended consequences begin.”
Economists are already warning that one crucial feature of the law might not turn out as planned: the law’s enshrinement of the “too big to fail” doctrine. During the crisis it was clear that some institutions—AIG, Citibank, and Goldman Sachs come to mind—were so interconnected that their collapse could topple the whole global banking system. One group of economists argued that the obvious solution was to break such behemoths into smaller, less dangerous entities. As Nobel Prize winning economist Joseph Stiglitz, put it: “If an institution is too big to fail, it’s too big.”
Yet Dodd-Frank does just the opposite. It separates banks with more than $50 billion in assets and certain other large financial institutions into a class of “systemically important” entities. The purpose of the special status is logical and well meaning: If the elephants of the system are identified, regulators can keep an extra close eye on them. The law subjects these big institutions to especially stringent rules, and the law gives regulators special authority to wind them down if they get into financial trouble.
The problem is, in the financial marketplace “systemically important” will inevitably come to mean “protected by the US government”. Banks enjoying Uncle Sam’s implicit banking will be able to borrow at lower rates than competitors, insuring that they will only get larger, more systemically important, and hence riskier. (Research shows that large banks already can borrow for more than three-quarters of a percentage point less than smaller competitors.) Something similar happened to Fannie Mae and Freddie Mac, the joint government-private home-loan packaging enterprises whose debt was long assumed to enjoy an unspoken US government guarantee. Under the implicit federal umbrella, the two lent and borrowed so recklessly that when the crisis hit, they had to be nationalized at an estimated ultimate cost to taxpayers of $73 billion. Economist Peter Wallison of the American Enterprise Institute and a long- time critic of Fannie and Freddie finds the similarity to the two misbegotten government-sponsored companies extremely troubling. “The identification of firms as too big to fail is a mad policy,” he says. “We’ve seen this movie before.”
Richard Skeel, a business professor and author of The New Financial Deal, a book about Dodd-Frank, argues that the new law carries an even more insidious “Fannie Mae” effect. Because the law gives regulators sweeping power over large banks, it invites politics into banking decisions. Skeel gives a hypothetical example:
Suppose, for example, that regulators are determining whether a group of Citigroup bankers are engaged in (a vaguely defined activity prohibited by Dodd-Frank) at a time when the government is unhappy with big oil companies or weapons manufacturers. It is not hard to imagine Citigroup’s directors concluding that they had better limit the bank’s financing of the disfavoured industry if they wish to get sympathetic treatment (from) the regulators.
Would that really happen? Skeel points out that during the 1990s and first decade of this century politicians of both parties used their influence over Fannie and Freddie to loosen lending standards for poorer and less creditworthy Americans. While that may have been good populist politics, it turned out to be disastrous financial policy. When those homeowners defaulted en masse in the crisis, Fannie and Freddie became wards of the state.
If Dodd-Frank does the opposite effect of what lawmakers intended, it won’t be the first time it happened in the US. Like Dodd-Frank, the Employee Retirement Income Security Act of 1974, or ERISA, arose in response to a financial disaster and was carried through Congress on the wings of good intentions—namely, to preserve private pensions for employees. However, the heavy regulation imposed by ERISA and subsequent well-meaning laws inadvertently gave employers incentives to replace pensions with more lightly regulated savings plans. Now, perversely, a little over 35 years after the passage of the law meant to save them, corporate pensions in America are all but extinct.
It is, of course, possible that regulators will use their new Dodd-Frank powers with perfect wisdom, foresight and restraint. It’s also possible that “systemically important” financial institutions won’t exploit the competitive advantage handed to them under the new law. But human nature—and history—suggest that things won’t turn out exactly as Congress planned. Any legislation as ambitious as Dodd-Frank always carries an important unwritten rider. Every lawmaker everywhere in the world must bow to it. It’s called the law of unintended consequences.
Eric Schurenberg is editor-in-chief, CBS Interactive Business Network, and former editor of Money.
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