SYSTEMIC CRISES AND THE COST OF REGULATION: THE DODD-FRANK ACT, THE EU SINGLE RESOLUTION MECHANISM AND UNEXPECTED LESSONS FROM FREE BANKING

Teemu Alexander Puutio[1]

 

A.  Systemic crises and political capturing

 

The global meltdown sparked by the 2007–2008 subprime mortgage failures gave momentum to a tidal wave of regulatory reactions. In the United States, Congress’ attempt at reigning in the mavericks of Wall Street came in the form of the ambitious Dodd-Frank Act[i], which aims to promote financial stability by improving accountability and transparency, ending bailouts, and protecting consumers from abusive financial services’ practices. To match its broad objectives, the act spans 848 pages where it creates new entities such as the Bureau of Consumer Financial Protection and addresses a multitude of complex issues, such as predispute arbitration, investor contracts, and beyond.[ii] Whereas the true litmus test of the act is in the lack or severity of future crises, several vocal groups have continued lambasting the act as either too stringent or diluted, largely correlating with their affiliation and levels of affection with Wall Street.[iii]

Whereas the United States financial market was well on its way to recovery in 2010 when the Dodd-Frank act was passed, the European Union was straddled with an economic malaise of seemingly infinite longevity. The sovereign debt crisis coupled with an all but universal export slump gave the reactions of supranational regulator a distinct flavor of urgency and intensity. Indeed, the European Union decided to pursue an European banking union by adopting three central pieces of regulation, namely No. 1093/2010 on the framework of a Single Resolution Mechanism and a Single Bank Resolution Fund,[iv] the Agreement on the transfer and mutualisation of contributions to the Single Bank Resolution Fund [v] both of which were to be joined by the Single Supervisory Mechanism regulation No. 1024/2013 that granted significant supervisory powers to the European Central Bank.[vi]  Together, this set of documents covers two of the three pillars of the banking union.

A few weeks ago, the financial regulators of the European Union had reason to celebrate as the Single Resolution Mechanism assumed full powers after a year of existence in preparation. From 1 January 2016, the Single Resolution Mechanism is responsible for the orderly and cost-efficient resolution of failed banks in the Eurozone and in other EU member states that choose to accede to the regulations mentioned above. The foundations for the final pillar of the banking union were laid down in November 2015, in the European Commission’s proposal for a European Deposit Insurance Scheme, which would provide retail depositors with uniform protection.

The continuing financial instability high unemployment levels, and sluggish export growth have proven fertile ground for these far-reaching financial reforms, knitting parts of the European Union into an ever-tightening federation. It is surprising how little attention the single biggest financial reform[vii] has received from the public sphere, which seems to be preoccupied with burning social topics such as immigration. This is not to say that the reform is without its share of naysayers, and whole countries such as the United Kingdom and Sweden have decisively rejected the union.

In addition to the responses by the European Union, the United States, and numerous other countries, the 2007 crisis also launched a truly global cascade of reforms through the Basel Committee. The ‘Basel III’ framework introduced in 2010[viii] aims to increase financial stability and shock-resilience with a mixture of micro- and macroprudential means. The essential reforms of Basel III include changes to key leverage ratios and liquidity requirements, the establishment of capital conservation buffers, and strengthened supervision and disclosure concerning issues particular to system-wide risks. The revised framework will be phased-in with the final thresholds and requirements coming into force in 2019. However, as the Secretary General of the Basel Committee on Banking Supervision stressed, the Basel III reforms are necessary but they are not enough.[ix] In particular, Basel III has been criticized over its inability to truly address systemic failures, which are not induced by low capital requirements per se.[x]

As anyone who has witnessed the development of the abovementioned reforms knows well, regulation is an inherently political process. As such, it is easily captured by short-term political goals and often fails to achieve long-term economic objectives.[xi] In the face of an almost universal reformist spirit it is important to remind ourselves that not all agree with the global consensus on tightening financial regulations. In fact, there is a steady if-not-strong undercurrent within financial and economic literature, which calls folly on any attempts to regulate the financial markets in the first place, and argues that any sensible nation that values efficiency in its financial markets should adopt a laissez-faire approach.

 

B.  Our history with free banking

 

Banking and financial markets have not always been strongly regulated by centralized governments.[xii] Since the establishment of the First Bank of the United States in 1791 and the subsequent expiry of its charter in 1811 after a failed vote to renew it, discussions around state sovereignty in financial regulation have remained as strong as they have been indecisive. To be sure, only after the devastation of the 1920’s financial crisis did centralized agencies such as the Securities and Exchange Commission and Federal Deposit Insurance Corporation merge, much to the benefit of individual depositors and market participants across the country. Even with the federal state thus encroaching on the states, banking regulation remained on a relatively ‘simple’ level, merely imposing ceilings on interest rates and restrictions on inter-state branching until rather recent times.[xiii]

As any advocate of free banking quickly notes, the banking history of the United States covers a period of particularly free competition for deposits and custom between banks and bank-like entities such as municipalities, railroads and even churches lasting until the late 1860’s, during which numerous operators entered the market with their private notes.[xiv] Even today, private currencies are not illegal in the United States and some communities such as Ithaca have chosen to issue them in support of their local economies.[xv] However, the golden days of the United States free banking were ended by the National Bank Acts of 1863 and 1864, which built the national banking system upon a uniform national currency.

Free banking was in no way limited to the United States, with several British Colonies, Latin American countries and Oriental states, including China and Japan, having had periods when banks were not significantly regulated and when note issuance was free.[xvi] Pre-1845 Scotland is often cited as the single most exemplary case where ‘remarkable monetary stability’ was achieved without monetary policies or  central banks, and with little to no regulatory restrictions on the banking industry.[xvii]

 

C.  Revisiting the laissez-faire manifesto

 

Inspired by such historical achievements, proponents of free banking such as Dowd, Selgin, Schuler and Whiteman claim that free banking systems would promote savings and investment by effective and low-cost intermediation, enhance the inexpensive and flexible allocation of credit and ensure that banks would be competed into both stability and providing higher returns on savings.[xviii] As noted by the aforementioned authors, eminent thinkers such as Milton Friedman, Anna Schwartz[xix] and Friedrich Hayek[xx] have also prominently questioned the role of government in banking.

Claiming that financial markets are best managed by free banking and laissez-faire regulations undoubtedly strikes most post-sub-prime-mortgage-crisis audiences nothing short of ludicrous. Indeed, the many moral and mechanical failures of Wall Street even with financial regulation in place make a strong case for the opposite. However, a careful examination of the laissez-faire manifesto reveals that the free banking Dowd et. al. advocate for is not free and totally unregulated banking per se but rather a series of more nuanced arguments about more efficient banking.

First, in his provoking paper ‘The Case for Financial Laissez-Faire’[xxi], Dowd claims that most economists approach the issue of financial regulation with the a faulty set of assumptions. In particular, Dowd argues that proponents of regulation ignore the fact that ‘if free trade is good […] there must be at least a prima facie case in favour of free banking’. Dowd further argues that the onus of proving that the principle of free trade does not apply to banking is on those who would dispute it.

Indeed, free trade does work, and embracing it has greatly increased the amount of globally available welfare, while not necessarily improving the distribution thereof. However, free trade is in no sense free from regulation – nor should it be.  On the contrary, trade in goods and services as a process, the production and features of the goods and services being traded, and the ultimate consumption of the goods and services are perhaps some of the most regulated areas in modern societies. The essence of free trade is the removal of transaction costs and boundaries that stand in the way of trade, making the process of allocating resources more efficient.

Consequently, the laissez-faire manifesto is best seen as a stream of arguments for reforming institutions and regulations that by their mere existence impose harmful inefficiencies, not for wanton abolishment of regulations concerning any and all aspects of banking.

In particular, proponents of free banking call for severe limitations on the powers that central banks hold over their monetary bases and for ‘depolitizing’ the money stock. Competitive note issuance and free chartering of intermediaries combined with light regulations such as disclosure requirements is argued to be a more efficient and inherently stable substitute for central banking. Secondly, laissez-faire agenda calls for an end to states’ ‘heavy-handed intrusions’ into market corrections by abolishing lender of last resort programs and implicit guarantees given to some or all banks. In the absence of harmful central banking and the perverse incentives of lender of last resort programs, it is argued that competitive forces would ensure an efficient allocation of risk and resources, intermediated by a host of flexible and unencumbered banks. The underlying message that stability always comes at a cost is well worth listening to.

 

D.  Improving our reactions to systemic shocks

 

Financial experts such as professor Shiller have noted that many of the reforms introduced by Dodd-Frank failed to address the most costly faults in the system. Some of the more persuasive arguments point out that regulators focused too heavily on addressing the ‘moral’ side of the equation without fixing the true source of systemic failure and costs, namely the inherent interdependencies and rigidities that define the modern globally connected financial system.[xxii] Recent contributions by e.g. Posner and Weyl further lament how modern financial regulation suffers from price-myopia as it relies heavily on qualitative measures and a narrow set of instruments, such as single bank prudential regulation, without justifying – and most importantly selecting – their interventions based on benefit-cost analyses.[xxiii]

Kurt Schuler’s statement that ‘Free banking’s historical record is more than a matter of mere antiquarian interest [—]. It has radical implications for present-day monetary policy[xxiv] finds its proper interpretation when taken as an exhortation to remain aware of the costs of regulation. Whereas such vigilance is particularly needed at times when systemic shocks have triggered a flight to safety and lowered the resistance to regulation, it is rarely forthcoming. As a result, the regulations that were proposed and ultimately passed were not subjected to the levels of cost-efficiency based scrutiny that they would have during more stable times.

To be sure, the efficiency and stability of the financial system would benefit from further reforms that divorce politics from financial regulation and impose measures that ensure time-consistency. Likewise, empowering consumers and increasing healthy competition between intermediaries could prove to be an expedient way of improving the current systems.  However, we should not rush to abolish central banks or adopt laissez-faire regimes. Rather, we should acknowledge that social costs are separate from private costs, and that it is the social costs that should ultimately guide social engineering and financial regulation, even while the proximate goals and interventions are aimed at minimizing private costs. Also, we would do well by remembering that regulating failures of systemic nature rarely requires one-size-fits-all solutions.[xxv] Indeed, all of the ‘functional branches’ of financial systems, namely payments, risk management, lending and borrowing, deserve tailor-made solutions.[xxvi]

As exemplified by the gusto with which financial markets are regulated today, it is safe to say that free banking and totalitarian laissez-faire is dead. However, the crux of the anti-regulation manifesto – a deep concern for the cost-efficiency of regulation – is an ideology worth reviving as we prepare ourselves for the next shock to come.

 

 

[1] Economic Affairs Officer at United Nations ESCAP;  LLB (University of Turku), LLM (University of Turku), PG Econ. (King’s College London), PhD candidate Faculty of Law, University of Turku and B.Sc. candidate at London School of Economics and Political Science;

 

[i] ‘Dodd-Frank Wall Street Reform and Consumer Protection Act’ available at SEC: https://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

[ii] See e.g. G. Friedman, “What’s a Regulator to Do? Mandatory Consumer Arbitration, Dodd-Frank, and the Consumer Financial Protection Bureau” (2014) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2706167

[iii] The heated discussion on whether Dodd-Frank is too strict, too lenient or unnecessary in the first place rages on in the academic and informal fora with keen and insightful lines of argument on both sides, as exemplified by, e.g., E. Posner, “We Don’t Need to End “Too Big to Fail” (2014) available at  http://www.slate.com/articles/news_and_politics/view_from_chicago/2014/07/house_dodd_frank_report_government_needs_to_be_able_to_bail_out_banks.html, J. Spross, “The demise of GE Capital: Why Dodd-Frank isn’t nearly tough enough“ (2015)  http://theweek.com/articles/549182/demise-ge-capital-why-doddfrank-isnt-nearly-tough-enough, and PublicCitizen, “Dodd Frank is Five And still not allowed out of the house” (2015) available at http://www.citizen.org/documents/dodd-frank-five-year-anniversary-report.pdf

[iv]Available at: http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014R0806&rid=3

[v]Available at: http://ec.europa.eu/finance/general-policy/docs/banking-union/single-resolution-mechanism/151217-delegated-regulation_en.pdf

[vi] Available at: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:287:0063:0089:EN:PDF

[vii] For an interesting exposition of how this far-reaching reform has been hidden behind arguments such as “it is only fiscal” see N. Véron “Europe’s radical banking union” (2015) available at: http://bruegel.org/wp-content/uploads/imported/publications/essay_NV_CMU.pdf

[viii] Basel III available at: http://www.bis.org/publ/bcbs189.pdf

[ix] W. Byres “Basel III: Necessary, but not sufficient” (2012)available at  http://www.bis.org/speeches/sp121106.pdf

[x] See e.g. N. Michel and J. Ligon “Basel III Capital Standards Do Not Reduce the Too-Big-to-Fail Problem” (2014) available at: http://www.heritage.org/research/reports/2014/04/basel-iii-capital-standards-do-not-reduce-the-too-big-to-fail-problem

[xi] See e.g. J. Campbell, H. Jackson, B. Madrian and P. Tufano “The Regulation of Consumer Financial Products: An Introductory Essay with Four Case Studies” (2014) available at  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1649647

[xii] For an illuminating history of the fragmentation of US financial regulation see A. Komai and G. Richardson “ A Brief History Of Regulations Regarding Financial Markets In The United States: 1789 To 2009” (2011) available at http://www.nber.org/papers/w17443.pdf

[xiii] One of the most ‘disruptive’ legislative acts is the “Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994″.  available at http://www.federalreservehistory.org/Media/Material/Event/50-254

[xiv] See e.g. L. White, “Banking without regulation” (1993) available at: http://fee.org/freeman/banking-without-regulation/#axzz2HD61ljXs.

[xv] See http://ithacahours.com/

[xvi] See e.g. K. Schuler “The world history of free banking An overview” (1992) available in edited volume at: http://www.libertarianismo.org/livros/KevinDowd_TheExperienceOfFree_Banking.pdf

[xvii] See e.g. L. White, “Free banking in Scotland before 1844” available in edited volume at: http://www.libertarianismo.org/livros/KevinDowd_TheExperienceOfFree_Banking.pdf

[xviii] See K. Dowd et al., “The experience of free banking” available at: http://www.libertarianismo.org/livros/KevinDowd_TheExperienceOfFree_Banking.pdf

[xix] M. Friedman and A. Schwartz “Has government any role in money?” (1987) available at http://core.ac.uk/download/files/153/6900301.pdf

[xx] F. Hayek, “The Constitution of Liberty” (1960), Published by Routledge & Kegan Paul

[xxi] K. Dowd, “The case for financial laissez-faire” available at: http://www.jstor.org/stable/pdf/2235576.pdf?acceptTC=true

[xxii] R. Shiller, “Reflections on Finance and the Good Society” (2014) available at: https://www.aeaweb.org/aea/2013conference/program/retrieve.php?pdfid=250

[xxiii] E. Posner, G. Weyl “Cost-Benefit Analysis of Financial Regulations” (2013) available at:  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2188990

[xxiv] See endnote xvi

[xxv] See endnote xi

[xxvi] See e.g. R. Merton and Z. Bodie “A Conceptual Framework for Analyzing the Financial Environment” (1995) available at: http://www.people.hbs.edu/rmerton/Conceptual%20Framework.pdf  and P. Tufano, “Consumer Finance” (2010) available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1599429


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