In Year Four of Dodd-Frank, Over-Regulation Is Getting Old

The Dodd-Frank Act was signed into law four years ago today, mandating sweeping changes in the way U.S. banks and financial markets are regulated. As implementation continues, it is increasingly clear that Dodd-Frank's unbalanced mix of new regulatory powers and vague goals are causing over-regulation and reducing economic growth.

The primary goal of Dodd-Frank — preventing another financial crisis — is not at issue. However, well-designed policies must balance costs against benefits. This is where Dodd-Frank fails. It excludes controls that prevent over-regulation and thereby creates incentives that encourage financial stability at the expense of financial intermediation — the monetary transactions that allow goods and services to be efficiently produced and traded, and the means by which consumers' savings are invested.

Dodd-Frank grants the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corp. and the Financial Stability Oversight Council vast new powers to regulate, with no checks on the exercise of these powers. Regulators are directed to exercise their new powers to ensure financial stability and mitigate systemic risk, but financial stability and systemic risk are never defined in the legislation.

A good example of the excessive discretion and hazy duties created under Dodd-Frank is Section 113 of the Act, which authorizes the FSOC to designate specific nonbank financial companies to be subjected to enhanced prudential supervision and regulation by the Board of Governors of the Federal Reserve System. The primary trigger is the FSOC's judgment that the firm's distress would cause financial instability. But in practice, the standards put few, if any, constraints on the FSOC's power.

The FSOC is not obliged to identify specific issues or features that mandate "designation," nor must it demonstrate how the designation will mitigate risks. While Dodd-Frank includes a requirement that, once designated, firms must file an annual orderly resolution plan that explains how they could be reorganized in a commercial bankruptcy without creating financial instability, the FSOC does not require this resolution plan as part of the designation process. Since an acceptable orderly resolution plan allows the firm to reorganize using bankruptcy without causing financial instability, it is clearly an oversight that the plan is not required in the preliminary designation evaluation.

The ambiguity of the designation standard provides the FSOC with virtually unlimited discretion. For example, under what conditions should the consequences of failure be evaluated: when the firm fails in isolation, or when the firm fails in a recession during which many other financial institutions are also distressed? Two very different standards may generate very different FSOC conclusions, and yet Dodd-Frank is silent on the issue.

One direct result of sloppy Dodd-Frank language allows the FSOC to make designations without knowing what heightened prudential regulatory standards will apply to designated firms. Not only has the FSOC designated nonbank firms without knowing the consequences of designation, but the justifications it has issued are so broad that companies are not provided with any guidance on how they might avoid designation.

New Dodd-Frank powers have been used to restrict financial intermediation in a number of ways. For example, bank regulators have prohibited banks from underwriting corporate syndicated loans that regulators judge to be too risky, even though these loans were to be purchased by bond mutual funds and not held by banks. The Federal Reserve has imposed its own judgment using Dodd-Frank mandated stress tests to raise the largest banks' capital requirements far above levels required by Basel III.

Moreover, recent speeches by senior Federal Reserve officials suggest that they will push to use Dodd-Frank powers to extend the Fed's ability to restrict financial investments and the use of short-term debt finance beyond the banking system to control the activities of shadow banks. The stated goal in each case is to prevent "bad" financial intermediation and promote financial stability. But in no case do any of the new rules recognize the cost on economic growth.

It is easy to understand how the imbalances in the Dodd-Frank Act led to over-regulation. Regulators' highest priority is ensuring that the financial system is stable; for them, slow or moderate economic growth is simply business as usual. But should a financial crisis arise, regulators would be disgraced. Dodd-Frank creates a clear bias encouraging over-regulation in the pursuit of financial stability because, for financial regulators, regulations are costless.

In 1978, the Congress faced a similar problem in specifying the Federal Reserve's goals for the conduct of monetary policy. The issue then was that the single goal of price stability encouraged the Fed to follow policies that controlled inflation by restraining economic growth and employment. The Humphrey-Hawkins Act addressed this issue by requiring the Fed to balance three goals: price stability, sustained long-run growth and full-employment.

Four years after the passage of Dodd-Frank, it is clear that Congress needs to revisit the legislation to prevent over-regulation in the pursuit of a single goal of financial stability. Dodd-Frank must be amended to require a balance of the following goals: financial stability, economic growth, and full employment. Otherwise, the economy will continue to get too much regulation and be short-changed on economic growth.

Paul H. Kupiec is a resident scholar at the American Enterprise Institute. He has also been a director of the Center for Financial Research at the Federal Deposit Insurance Corporation and chairman of the Research Task Force of the Basel Committee on Banking Supervision.