Prasad Krishnamurthy is Professor of Law at the U.C. Berkeley School of Law. This post is based on a recent article by Professor Krishnamurthy, forthcoming in the Yale Journal on Regulation.
Like many pieces of financial legislation, the Dodd-Frank Act of 2010 was passed in the aftermath of a major financial crisis. Such crises have been a recurring feature of U.S. economic and political history since at least the nineteenth century. Nevertheless, it is only their aftermath, when the embers of the financial system are still aglow, that the necessary public support may exist for fundamental legislative reform. Once the crisis passes, memories fade and the public turns its attention to other matters, political and otherwise. The financial industry can then look forward to a period of benign neglect, during which it can more decisively influence Congress and the federal agencies.
The immediate aftermath of financial crises are an exception to the public-choice rule, articulated by George Stigler, that regulation mostly exists for the benefit of the regulated industry. Most major pieces of financial regulation—from the National Bank Act of 1864 on up to the Federal Reserve Act of 1914, the Banking Acts of 1933 and 1935, and the Dodd-Frank Act of 2010—imposed substantial costs on powerful, incumbent financial interests. In the periods between crises, however, the banking industry is better able to preserve opportunities for profit. For example, few would dispute the idea that the Interest Rate Adjustment Act of 1966, which set maximum rates of interest on deposit and savings accounts, ultimately redounded to the benefit of the banking industry.
It is now almost eight years since the passage of the Dodd-Frank Act and, consistent with Stigler’s dictum, banks have begun to chip away at its regulatory edifice. On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act. Commenters will likely debate the Act’s likely impact on economic growth and consumer protection, but there will be less disagreement over whether it provides regulatory relief to affected banks. The Act relieves all bank holding companies with assets between $50 billion and $250 billion from their duty to comply with the Dodd Frank Act’s enhanced prudential standards. The federal banking agencies next plan to overhaul the Volcker Rule, which attempts to prevent the largest banks from engaging in risky forms of proprietary trading.
If the past is any guide to the present, these changes are likely to embolden affected banks to take on greater risks. Added risks bring returns, but the net effect of these changes may be to leave the financial system more vulnerable to future crises. As the recent financial crisis sharply illustrates, banks and other financial institutions that are funded with panic-prone, short term debt pose unique risks to the financial system. Consequently, this regulatory retreat raises the question whether the financial system will remain resilient in the face of future shocks similar to the housing crisis of 2008-2009.
In my new article, George Stigler on His Head: The Consequence of Restrictions on Competition in (Bank) Regulation, I suggest that the banking system remains unnecessarily vulnerable to such shocks. There are two, interrelated reasons for this vulnerability. First, the Dodd-Frank Act’s enhanced prudential standards—and the Basel paradigm on which they are based—place far too great a burden on regulators to closely monitor the risks of the largest, most complex banks. Enhanced prudential regulation turns largely doubles down on the Basel Accord’s existing structure of capital requirements, liquidity requirements, and stress tests. These, in turn, require regulators to accurately assess the systemic or undiversifiable risks on the aggregate balance sheet of the banking sector. Of course, the Basel approach is not without its merits. Set at high enough levels, capital and liquidity requirements can provide regulators with a large margin of error, especially if they can establish underwriting requirements for safe classes of bank assets. It is unlikely, however, that current capital and liquidity requirements are set high enough to account for the likelihood that both bankers and regulators, being human, can fail to assess these risks. The asset side of the balance sheet also provides little comfort. Regulators have little ability or inclination to set underwriting standards outside of the market for conformable mortgages.
Second, the architecture of the Dodd-Frank makes it particularly vulnerable to regulatory arbitrage. This arbitrage can take place through regulatory evasion by banks, adoption of banking activity by nonbanks, and/or the political erosion of formal and informal regulatory constraints through the lobbying activity of banks. The main tools of Basel bank regulation—capital and liquidity requirements—act like a tax on profitable opportunities for risk taking in the regulated banking sector. As such, these requirements create strong incentives for banks to undermine the effectiveness of regulation over time through legal, economic, and political action.
Paradoxically, I suggest that the financial system could actually be made more resilient by further involving the banking industry in the formation and enforcement of regulation. If the past is any guide to the present, then financial regulation works best when its goals are aligned with the profit-making imperatives of regulated banks. I illustrate this claim by examining the way that bank regulation operated in quiet period from the end of the Great Depression to the saving-and-loan crisis of the 1980s. I show how a combination of deposit insurance, interest rate controls on deposits, and activity and entry restrictions on banks and bank competitors—each embedded in a federal system of statutes and regulations—acted to create rents for the banking sector.
The post-New-Deal system helped to maintain a more stable legal, political, and economic (LPE) equilibrium in the banking and broader financial system over a number of decades. In particular, the rents created through price, quantity, and activity restrictions on competition helped to solve two problems that are central to contemporary bank regulation. First, they lowered the incentives of banks to take excessive risk and, crucially, did so without requiring regulators to precisely monitor risk-taking activities. Second, they created incentives for banks to prevent banking activity from moving outside the regulated banking system.
The LPE architecture of this system created the incentives, monitoring capability, and enforcement authority to achieve these ends. As a synecdochic example, I analyze the way in which banks dealt with the threat posed by Negotiable Order of Withdrawal (NOW) accounts, which emerged as a competitor to bank deposits in the 1970s. More generally, I describe how the emergence of deposit substitutes such as Eurodollar deposits and money market mutual funds eventually eroded bank rents in the context of a high-inflation environment. I conjecture that the theory of oligopoly, a mainstay of public choice critiques of regulation, can explain the historical effectiveness of bank regulation during the quiet period.
This view of bank regulation turns the usual, public choice account on its head. The presence of rents in banking—unlike in industries where natural monopoly is a primary concern—served an important historical function. Undermining these rents, in turn, contributed to aggressive risk taking by banks and other bank-like institutions. Of course, aggressive risk taking has its place in any financial system, but such risky assets should be backed by financial claims on equity or long-term debt. For these securities, bad news gets impounded in prices through trading on secondary markets, as opposed to the withdrawal of funds from the financial system and, in turn, the real economy.
I build on this historical analysis by outlining a model of bank regulation that seeks to apply these past insights to the present. In this model, prudential regulation operates so as to limit the amount of short-term, panic-prone debt that could be issued by bank holding companies. Regulation simultaneously extends to non-bank financial companies so as to even further limit their issuance of such debt or its close substitutes. This model creates a legal framework of privileges and prohibitions that limits the aggregate quantity of such debt and concentrates it in the regulated banking sector. The effect is to raise the price of panic-prone debt and lower its yield, creating a rent or funding advantage for regulated banks. The use of regulation to affect prices in this market is no different in kind than Federal Reserve policy to affect short-term interest rates in the pursuit of monetary policy. However, it has the additional effect of limiting bank incentives for risk taking to preserve a utility model of safe returns, while enlisting banks to protect this privilege by aiding regulators in their enforcement against nonbanks.
In conclusion, it is often the task of regulation, financial or otherwise, to limit the quantity of an externality-producing good in an environment where regulators face a number of monitoring and enforcement constraints. In such environments, it may be useful to create a legal privilege through which the price benefits of the quantity limitation redound to a privileged oligopoly. Such a rent would normally give those so privileged, as well as their unlucky competitors, an economic incentive to expand output. Expanding output, however, undermines the effectiveness of regulation. This tendency can be balanced through a legal and political architecture that enables the oligopoly to collectively prevent such an expansion from occurring.
The complete article is available for download here.