NEW YORK – September will mark a decade since the beginning of the Great Recession. In the wake of the crippling financial crisis, Congress and the Federal Reserve moved swiftly to take corrective action – from the Dodd-Frank Wall Street Reform, to the Volcker Rule and stress tests, to the Consumer Protection Act. But the rush to pass and enforce regulations has not only proved ineffective, but counterproductive according to recent research from Columbia Business School Professor Charles Calomiris. The new article – Has Financial Regulation Been a Flop? (or How to Reform Dodd-Frank) – details numerous flaws in post-crisis financial regulations and proposes modifying or eliminating a number of recently approved financial reforms, including pieces of Dodd-Frank and the Volcker Rule.
"The Great Recession created a rush in Washington to establish guardrails for the financial industry," Calomiris said. "But good intentions, expanded powers, and new mandates do not necessarily lead to smart policy decisions. Ten years later, it’s clear that the Dodd-Frank Act and further regulations are failing to curb risky behavior while obstructing economic growth. We can do much better than these costly, unsustainable regulations that will do little to prevent a repeat of the financial crisis."
In the article, Calomiris broadly examines a number of Congressional regulations and Federal Reserve actions, explaining how the combination of capital requirements and lending rules have created a host of new costs and risks for large banks stemming from constantly changing prudential standards, actions by the newly-established Financial Stability Oversight Council, and the Federal Reserve administered stress tests. At the same time, small banks face a "morass of new rules and compliance burdens" that put them at a severe disadvantage. The combination of these two effects is limiting economic growth.
Calomiris details the numerous shortcomings of key financial regulations, including the Fed’s misaligned incentives on mortgage-backed securities, Dodd-Frank’s failure to set meaningful capital standards for banks, the lack of clearly defined standards for stress tests, the Volcker Rule’s negative impact on banks’ market-making ability, and the unintended consequences of both the CARD Act and the Durbin Amendment. Calomiris highlights 10 principles, grounded in economic and legal values that a prudential financial regulation should consider, along with 22 proposed reforms to the current regulations. His proposed reforms include:
- Link financial regulation directly to the performance of the financial sector and demonstrate that regulatory costs are justified by measurable benefits.
- Restore the role of laws and formal rule-making in financial regulation and end the discretionary authority of politicized actors like the FSOC and the Consumer Financial Protection Bureau.
- Hold regulators accountable to the public by requiring transparent regulatory standards.
In addition to the proposed phasing out the use of guidance in financial regulation and replacing it with formal rule-making, the article also proposes reforms, including:
- Delay the further use of stress tests as a regulatory tool until realistic scenario forecasts can be constructed.
- Wind down the Federal Housing Authority, Government-Sponsored Enterprises like Fannie Mae and Freddie Mac, and Federal Home Loan Banks and replace mortgage risk subsidies with means-tested down payment matching subsidies.
- Create tax-favored housing savings accounts to further promote affordability of housing.
- Phase in limits constraining banks to < 25% of loans for commercial or residential real estate.
- Replace the morass of capital ratio requirements on banks with a single leverage limit and a single minimum ratio of book equity to risk-based assets.
The article, Has Financial Regulations Been a Flop? (or How to Reform Dodd-Frank), published in the Journal of Applied Corporate Finance, is available online at: https://onlinelibrary.wiley.com/doi/abs/10.1111/jacf.12258
To learn more about the cutting-edge research taking place at Columbia Business School, please visit www.gsb.columbia.edu.
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