The rolling Back of Dodd-Frank and other tales of twists by Rick Rowden.

In May 2018, the US watered down some of the major financial sector regulations it had adopted in the wake of the 2008 global financial crisis. The dilution of the Dodd-Frank financial reforms should be seen within the broader historical context regarding the growth in the size and political power of the financial services industry in the US over the past four decades – and its ability to influence policy, even when this conflicts with democratic oversight and the public interest.

While large economies certainly need an effective financial sector, the US finance, insurance and real estate sector today accounts for 20% of GDP, having doubled in size since 1947. Many economists, academics and politicians warn that the financialisation of the economy can lead to an unhealthy increased reliance on the financial sector to create GDP growth. Left uncontrolled, these dynamics can exacerbate many problems such as worsening economic inequality, growing levels of public and private debt, slow growth and more frequent financial crises.

“Collectively, the 25 newly deregulated banks hold US$3.5 trillion in assets, or roughly one-sixth of the assets in the entire banking sector.”

One of the major items in Dodd-Frank that has been weakened relates to the question about at what size they (banks) begin to present a systemic risk to the economy if they fail. The Dodd-Frank reforms required all bank holding companies with over US$50 billion in assets to comply with new, stricter rules but new legislation introduced in May (see box) increased the threshold for when these stricter regulations kick in, increasing from over US$50 billion in assets to those with assets of US$250 billion. Critics of the change noted many of the deregulated institutions that contributed to the 2008 crash had been capitalised at much less than US$250 billion.

Nevertheless the number of “systemically important financial institutions” subjected to the higher standards was dropped from 38 to 13 with the stroke of Trump’s pen. Collectively, the 25 newly deregulated banks hold US$3.5 trillion in assets, or roughly one-sixth of the assets in the entire banking sector, and are clearly “systemically important”. Several of these banks needed to be bailed out by taxpayers for a total of US$47 billion during the 2007–2008 financial crisis because of the risky, bets they had engaged in. They include the US arms of Deutsche Bank, BNP Paribas, UBS, and Credit Suisse, or, as the Center for American Progress noted, “the last banks on earth that should be deregulated.”

“The whole legislative effort was wrapped in the guise of providing regulatory red-tape relief for struggling community banks.”


The whole legislative effort was wrapped in the guise of providing regulatory red-tape relief for struggling community banks. However this was a ruse because they have actually been doing quite well, with over 95% of community banks making a profit today, up from 79% when Dodd-Frank was passed, according to the FDIC. The claim that reforms to Dodd-Frank were necessary to help bigger banks that were suffering under too much regulation was also a ruse. Over the previous three years, bank profits and lending were both at all-time highs for banks of all sizes.

Although there are some minor consumer provisions in the new legislation, such as the right to free credit freezes and protections for veterans’ medical debt, the overall thrust of the changes are overwhelmingly set to benefit the banks, not consumers. The Dodd-Frank rewrite did nothing to address the recent scandals at Wells Fargo and Equifax which harmed consumers, or the mounting crisis of nearly US$1.5 trillion in student debt.

In fact, rather than help consumers, the deregulation is very likely to harm consumers going forward. For examples, the Office of the Comptroller of the Currency has weakened bank assessments under the Community Reinvestment Act and opened the door to a form of predatory payday lending by banks and the reforms roll back data requirements designed to highlight discrimination in lending practices set up in the 1970s.

Additionally, one of the better things to come out of Dodd-Frank, the Consumer Financial Protection Bureau (CFPB), is being destroyed from within by Trump’s appointed acting director, Mick Mulvaney. Under Mulvaney, the CFPB recently dropped its investigation into the Equifax scandal and is basically refusing to undertake its oversight duties.

For example, towards the end of the Obama administration, the CFPB had established an important arbitration rule that would have restored consumers’ right to band together to take financial companies to court in class-action lawsuits. But during the Trump administration the rule was overturned so consumers remain stuck in small-print obligations with arbitration as the only remedy for redressing grievances.


The next crisis
According to executive director of Americans for Financial Reform, Lisa Donner, “This legislation ignores the lessons of the financial crisis that cost so many Americans their jobs and homes, and pays no heed to the overwhelming majority of voters who correctly understand the need for tougher, not weaker, oversight of the financial services industry.”

The same degree of risk that major Wall Street banks posed in the lead up to the 2008 crisis still exists. Today large banks remain too complex, too big and too risky to the global economy to be allowed to fail in a crisis. So taxpayers will bail them out again when their excessive overleveraging sparks the next crisis. The fact that they know they will get bailed out leads to what economist call a moral hazard – a perverse incentive to act recklessly because they know they will get bailed out in a crisis. The moral hazard is exacerbated by the low penalties and weak regulatory oversight, which encourage adopting fraudulent banking practices as regular features in the banks’ business models.

Last year, Bloomberg reported the hedge fund industry has officially gone over US$3.02 trillion in global assets under its management. Particularly worrying is the high amount of derivatives being traded in the global market largely unregulated. They are used to hedge against risks on other bets, much like placing a bet on a bet. This was one area where the Dodd-Frank reforms had no meaningful impact.
And the record-breaking levels of gambling are being matched by record-breaking highs of debt. Earlier this year the IMF reported that by 2016, the global level of debt was equivalent to 225% of global GDP.


The servant is the master
Ostensibly, the financial sector serves the real sector  – producers of real goods and services – by providing the investment capital needed to expand businesses, create jobs and promote economic growth. But financial deregulation has created opportunities for the financial sector to make higher returns by doing other things. Casino speculation presents many more, higher risk/higher-reward opportunities for investors. And the long-term political and policy consequences of letting this trend go unchecked decade after decade is the best way to understand the path that led to the 2018 rolling back of the Dodd-Frank reforms.

If the biggest banks are truly too big to fail, then they should be broken apart, in line with traditional anti-trust best practices. The reason why this is not happening is because of the regulatory capture and even state capture by the financial services industry.

So the new normal is that banks no longer make most of their profits by earning interest on loans. Instead, they make more profit by charging fees for services, penalties and other fees. Michael Hudson explained that banks have increasingly adopted the role of bookies for customers to place bets on Wall Street’s financial horse race – which way stock prices, bond prices, and foreign currency shifts are going to go. It’s also much faster and easier to make high profits on speculating in asset price bubbles, such as for real estate, than to invest in real sector companies.

“Since the 1980s the lobbying prowess of the financial services industry has completely twisted the purpose of bank regulation.”

Since the Great Depression in the 1930s, the purpose of bank regulation has been to insure depositors in the case of a bank failure. If banks made bad loans, they would be penalised, sanctioned or dissolved and its directors could face criminal penalties. But since the 1980s the lobbying prowess of the financial services industry has completely twisted the purpose of bank regulation to now mean ensuring that the banks won’t lose out if something goes wrong. Today, if a bank makes bad loans, the customers or the government or both will bear the financial costs, not the bank. Thus, the servant to the economy has become the master.

It’s important to understand that as finance becomes a larger and larger portion of the economy and remains mostly unregulated, it morphs in ways that become perverted and harmful for the real sector.

As a result of this process of financialisation, investment capital (cash) has been concentrating and pooling as increasing numbers of institutional investors and high-net-worth individuals seek higher returns from the global casino than from investing in actual companies in the real sector. But because there are not enough profitable investment opportunities to meet the growing demand of these high-risk/high-reward investors, the cash pools up into trillions of dollars just waiting for new investment opportunities.

The pressure to find higher risk/reward investment opportunities has led banks, institutional investors and asset managers, pension funds and insurance companies on a relentless search to find “passive” assets that can be sliced, diced and re-packaged for use as collateral for various purposes in the so-called shadow banking system – the complex global networks of credit, liquidity and leverage which operates beyond the reach of the normal banking system regulators.

Lengthening of the leash
Following the 2008 global financial crisis, the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank legislation attempted to establish new rules and restrictions on the activities of the financial sector. Despite its many shortcomings, the legislation is broadly credited with strengthening the US financial system in several ways, including by imposing higher capital requirements on banks, identifying “systemically important financial institutions” and requiring more transparency in derivatives. It also established the Consumer Financial Protection Bureau (CFPB) to protect borrowers from fraudulent lending practices. Dodd-Frank had many critics across the spectrum, from those who believed the new rules and restrictions went too far to those who believed they did not go far enough.

In the end, those who claimed it had gone too far won the day.

On May 24, 2018, US President Donald Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act, which basically rolled back many of Dodd-Frank’s main rules which included stronger capital and liquidity requirements (reserves), enhanced risk management standards, living-will requirements, and meeting semi-annual stress testing requirements. .

Other crucial changes included:

  • the required frequency of company-run stress tests for big banks from undertaken on a “semi-annual” basis to a “periodic” basis and reduce the number of scenarios that have to be run;
  • institutions with less than US$10 billion in assets and low levels of trading assets and liabilities were given exemption from the firewall, or division, known as the Volker Rule, that was designed to prevent federally-insured banks from using deposits for risky financial speculation; and
  • the Liquidity Coverage Ratio requiring banks to maintain a certain amount of capital to be available for covering losses in a crisis has been reduced and diluted.

According to Storm, what is most distinctive about the present era of finance is the shift in financial intermediation from banks and other institutions to financial markets, “a shift from the ‘visible hand’ of (often-times relationship) regulated banking to the axiomatic ‘invisible hand’ of supposedly anonymous, self-regulating, financial markets.” This transformation in the locus of decision-making has had “a pervasive influence on the motivations, choices and decisions made by households, firms and states as well as fundamental quantitative impacts on growth, inequality and poverty—far-reaching consequences which we are only beginning to understand.”

As these large pools of investment capital sit around idle and waiting for riskier bets, there also far less finance capital available for real sector companies, which creates a drag on economic growth in over-financialised economies such as the US, the EU and India. Even major international economic organisations such as the Bank for International Settlements (BIS) and the International Monetary Fund (IMF), which generally favor the financial sector, have issued warnings about the danger of letting finance get too big.

For example, in 2015, the IMF warned that while a finance sector can assist in a country’s economic growth, it only does so up to a point. It acknowledged that there is a critical threshold after which the size of the financial sector can begin to cause countries to suffer from “too much finance” as financial resources are used less efficiently overall because investments are increasingly diverted into speculation and away from productive activities.

Additionally, there are added costs associated with increased financial volatility and financial crises. In other words, as the financial sector grows in size, “the positive effect on economic growth begins to decline, while costs in terms of economic and financial volatility begin to rise.”

Using data for 128 countries collected between 1980 and 2013, the IMF found that economies such as Japan, the US and Ireland had already crossed this threshold when financial sector expansion starts to provide fewer benefits to growth and eventually leads to diminishing returns (the study did not publish the data on China, Germany or the UK, where finance plays a significant role). So when the servant becomes the master, it also begins to kill off the goose that lays the golden eggs (the real sector).

Many observers note that this trend was not a natural phenomenon, but was encouraged, enabled and aided and abetted by a willing political class who shepherded the right policies and political choices over the last few decades. In the case of the US, this includes the leadership of both the Republican and Democratic political parties who bare responsibility for creating the monster that has been unleashed. University of South Carolina professor of political science, Christopher Witko, underscored the importance of the series of political decisions that have been taken by both parties that paved the way for financial deregulation over the last few decades.


Financial triumph
With both political parties essentially bought off, the triumph of finance is nearly complete.

Among the most insidious features of the Dodd-Frank rewrite is that the entire effort amounted to a blatant end-run around democracy and the public interest: There was no popular movement of voters mobilised and calling for further Wall Street deregulation; There are no practical reasons for why it is in the public interest to reduce oversight of some of the largest banks and give a green light to medium-sized banks to gamble with taxpayer-backed deposits and discriminate against borrowers; and yet it was done anyway. Rather, it was an entirely industry-driven lobbying effort that was able to buy enough votes to carry the day.

Opponents to the changes, such as consumer groups, advocacy organisations and many politicians, ominously failed to mobilise enough political opposition to stop them.

Adding insult to injury, when stress tests in June 2018 showed that the massive investment banks Morgan Stanley and Goldman Sachs did not have enough assets to allow them to weather a financial crisis, both failed the tests. But they got regulators to twist around the way the tests were graded, so they earned passing grades.  The US Federal Reserve still allowed the banks to pay out billions of dollars in profits to their investors which, under the normal rules, should have been withheld by the banks for building reserves. The Germans face a similar problem, with Deutsche Bank, which also keeps failing its stress tests, without sanction.

Some day voters, consumers and policy makers will doubtless see the folly of their ways and finally take the necessary steps to break apart and rein in finance. Sadly, it looks like that day will only come once it is too late… again.


Rick Rowden is a writer and PhD Candidate in the Centre for Economic Studies and Planning at Jawaharlal Nehru University in New Delhi.

Rick Rowden

Rick is Senior Economist as Global Financial Integrity (GFI) and has a Phd in economics from Jawaharlal Nehru University in New Delhi. Previously he worked as an inter-regional advisor for …

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