Why Dodd-Frank has already failed

Justin Fox’s take in the Harvard Business Review is spot on:

Relying on regulators or central bankers doesn’t always work because during good times they have a habit of getting caught up in the same idiocy as the financiers do.

A case in point is the atmosphere of self-congratulation that infused the last days of the Greenspan Fed. The recently released transcripts from the 2006 FOMC meetings make this clear, with plaudits like the following from then-San Francisco Fed President Janet Yellen:

[A]s I look at the total picture, I would say that the overall outlook is quite positive. The economy is near full employment with real GDP tending toward trend-like growth. Core inflation is within a reasonable range but a bit on the high side. Needless to say, it’s fitting for Chairman Greenspan to leave office with the economy in such solid shape. And if I might torture a simile, I would say, Mr. Chairman, that the situation you’re handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot.

Yes, regulators and central bankers do pass the Kool-Aid around when things are going well. This is also at the root of why Glass-Steagall fell victim to a “break-the-law-first-and-ask-questions-later” attack.

But what can we do if it’s the case that the prison guards always end up being seduced by the prisoners? As Fox explains, this is why “attempts at controlling the industry’s bad habits have also involved restricting what different institutions can do, and how they are organized.” Financial institutions are rambunctious toddlers: give them time and they will, eventually, hurt themselves. (And us.) So best to design the kiddie playground with that in mind.

Now the kiddie playground of today was designed by a couple of architects called Dodd and Frank. Did they do a good job? Well Josh Rosner doesn’t think so, and told Congress this last May. The emphasis is mine:

Dodd-Frank reinforces the market perception that a small and elite group of large firms are different from the rest. While the act sought to reduce the risks that too-big-to-fail (TBTF) institutions pose to the financial system and the broader global economy, it is unclear whether any such meaningful reduction has actually occurred. Moreover, although not fully implemented, Dodd-Frank has not reduced the number of systemically risky firms or placed meaningful new limits on their size, interconnectedness, or leverage. In fact, since the crisis began the largest financial firms have become even larger. In 1995 the assets controlled by JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley represented 17 percent of GDP; as of January 2011 these firms controlled assets equal to 64 percent of our nation’s GDP. Today, the five largest banks, which controlled slightly more than 10 percent of deposits in the early 1990s, control over 45 percent.

And Thomas Hoenig, who’s now the head of the FDIC of all places, agrees with him:

It’s well-intentioned. I understand. But the question you have to ask is, have you changed the incentives, really? [Systemically Important Financial Institutions aka SiFis] still have a safety net. Everyone knows you’re going to lend to them in a crisis. Creditors know they’re going to be able to bail…I just think it is inherently flawed, because you still have the same incentives around the safety net, you haven’t spun out the high-risk activities, so you are bound to repeat the same events. I don’t know when. Two years from now? Twenty years from now? But you are bound to repeat them.

Smart investors would do well to remember this.

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Tags: Alan Greenspan, bailouts, Banking, Dodd-Frank, economic news, economics, Federal Open Market Committee, FOMC, Glass-Steagall, Janet Yellen, Justin Fox, San Francisco Fed, SiFis, TBTF, Thomas Hoenig, Too Big to Fail, United States, US

Category: Banking