Deregulating Wall Street

When a large part of the financial sector is funded with fragile, short-term debt and is hit by a common shock to its long-term assets, there can be en masse failures of financial firms and disruption of intermediation to households and firms. Such disruptions became particularly intense in the fall and winter of 2008–2009, following the collapse (or near collapse) of some of the largest financial institutions. In this period of extraordinary financial strain, the economy and financial markets tumbled in the United States, Europe, and elsewhere.

In the aftermath of this disaster, governments and regulators cast about for ways to prevent—or render less likely—its recurrence. The existing regulatory framework was wholly unsuited to dealing with systemic risk: the widespread failure of financial institutions and freeze-up of capital markets that impair financial intermediation. In the United States, this recognition led to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Faculty at the NYU Stern School of Business and the NYU School of Law provided a detailed analysis of the strengths and weaknesses of Dodd-Frank in Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (2011). Drawing on this book, in a 2012 piece in the Annual Review of Financial Economics, Acharya & Richardson offered an economic assessment of Dodd-Frank in terms of the likely efficacy of the proposed financial sector regulation, with some emphasis on the act’s unintended consequences.

Given the passage of time, and with the change in power in Washington, DC, the NYU faculty in 2017 reinvestigated Dodd-Frank and for illustrative purposes compared it to legislation, the Financial CHOICE Act, passed by the US House of Representatives. While the CHOICE Act did not become law, it represents one possible approach to repealing parts of Dodd-Frank and streamlining regulation, and it continues to represent an important strain of thought on these topics. Indeed, the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCP Act, S. 2155)—enacted May 24, 2018—embodies some of the ideas from the CHOICE Act. That 2017 NYU faculty book, Regulating Wall Street: CHOICE Act Versus Dodd-Frank, provides a topic-by-topic analysis of Dodd-Frank and the CHOICE Act’s two approaches to regulation. Not unlike the aforementioned Annual Review of Financial Economics piece, the current article summarizes our main findings on the possible deregulation of Wall Street.

Systemic risk arises when there is a breakdown in aggregate financial intermediation, which in turn results from aggregate capital shortfalls and liquidity shortfalls in the financial system. When investors or depositors question the extent to which a class of financial institutions or the financial system as a whole can absorb losses, access to short-term funding and liquidity dries up, which prevents even solvent institutions from taking over the financial intermediation activities of failed firms.

It follows, therefore, that the systemic risk of individual firms relates to how these firms contribute to this aggregate capital shortfall. A financial firm might rationally have high leverage or engage in risk-taking activities that are optimal on an individual basis but that—aggregated with all other financial firms—lead either to too much leverage or to greater risk emanating from the financial sector. This negative externality suggests the need for prudential regulation. With respect to such regulation, the regulator can pull on one or more of three levers: capital (i.e., equity funding) requirements; liquidity requirements; and regulation of scope (such as restrictions on activities or asset holdings).

Dodd-Frank employs all three of these levers. As indicated, the CHOICE Act, the recent sequence of US Treasury reports on financial regulation, and the enacted EGRRCP Act aim to reduce the burden of financial regulation. Indeed, all three recent efforts would dial back one of the three Dodd-Frank levers: the regulation of scope.

In our view, the CHOICE Act correctly views stronger capital requirements as a substitute for other forms of regulation. Ceteris paribus, higher bank capital—i.e., more equity finance—provides a buffer that protects a bank’s creditors against the bank’s risk exposures, thus reducing the likelihood of its failing and, when applied broadly across the financial sector, resulting in a lower probability of an aggregate capital shortfall. Banks with sufficient capital require less supervision and regulation of scope because the bank shareholders have better incentives. That is, they are on the hook for more of the bank’s initial losses.

In other words, the greater is bank capital, the smaller are the benefits of other forms of financial regulation in reducing systemic risk. This key point was missed or downplayed by Dodd-Frank. Of course, these higher capital requirements need to be judged against the costs of capital regulation.

Nevertheless, we are fairly critical of many features of the CHOICE Act’s approach to systemic risk management, a number of which are discussed below. For the largest, most complex, and most interconnected institutions, we emphasize the need for strict scrutiny to ensure that capital is adequate in a crisis and that resolution is feasible with limited spillover effects.

In our article, we first provide a brief assessment of Dodd-Frank. We next discuss the tradeoff of higher capital requirements against regulation of scope. We compare key features of Dodd-Frank to those of the CHOICE Act as a way of thinking about financial regulation. We focus in particular on the Volcker Rule. Indeed, a considerable portion of our article is devoted to the proposition that regulation of scope is likely an inferior way to manage systemic risk.

We conclude that implementation of Dodd-Frank has contributed significantly to the reduction of systemic risk in the United States. It is important to maintain that progress. At the same time, however, Dodd-Frank addressed these risks only incompletely and, in some cases, introduced burdensome rules that have little to do with systemic risk.

The Volcker Rule is a good example of excessive regulatory burden. Taking into account the disconnect between the Volcker Rule and risk, along with the Rule’s steep costs of compliance, our article concludes that policymakers who wish to limit systemic risk should scrap the Volcker Rule in favor of other prudential tools, such as risk-weighted capital requirements, leverage ratios, liquidity ratios, living wills, and stress tests. Where other regulations of scope exhibit a comparable cost-effectiveness deficiency, the same conclusion would apply.

To be clear, the point is to make the financial system more resilient by shifting to greater use of regulatory tools that do so with the lowest cost. From this perspective, we are concerned about recent deregulatory efforts that scale back some of the successes of Dodd-Frank, especially the heightened supervision framework that applies to a small number of large, highly interconnected intermediaries. For example, although there are some worthwhile elements in the recently enacted EGRRCP Act, we fear that the troubling elements in the Act are a harbinger of future rollbacks of sensible prudential regulatory provisions that will cause the US financial system to be less resilient and more prone to future problems.

The complete article is available here.