Recession Safeguards Are Coming Under Heavy Attack

Special Report from Money Morning

by Shah Gilani, Money Morning

Lackluster economic growth in the U.S. has nothing to do with financial services regulatory overreach inherent in new Dodd-Frank rules – as some neo-conservatives would have the American public believe.

Let me say, I’m a staunch fiscal conservative. I am a dyed-in-the-wool free markets entrepreneur. But there’s a world of difference between free markets and a free-for-all for financial services oligarchs and officers.

In a July 21, 2014 American Banker article commemorating the four-year anniversary of the signing into law of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Paul H. Kupiec, a resident scholar at the American Enterprise Institute (AEI), makes the misguided case that Dodd-Frank is what’s holding back the recovery.

Here’s a look at how a recession prevention backstop is coming under siege…

Understanding the (Flawed) American Banker Argument

Just because Mr. Kupiec has been a director of the Center for Financial Research at the Federal Deposit Insurance Corporation and chairman of the Research Task Force of the Basel Committee on Banking Supervision, before hanging his hat at the AEI, doesn’t mean his position on behalf of the big-business-centric American Enterprise Institute is objective. It’s not.

You can see the July 21 issue for the entire article, but here are excerpts of what Mr. Kupiec wrote in American Banker with my counterpoints attached; see the July 21 issue for the article in its entirety.

The primary goal of Dodd-Frank – preventing another financial crisis – is not at issue. However, well-designed policies must balance costs against benefits. This is where Dodd-Frank fails. It excludes controls that prevent over-regulation and thereby creates incentives that encourage financial stability at the expense of financial intermediation – the monetary transactions that allow goods and services to be efficiently produced and traded, and the means by which consumers’ savings are invested.

Shah: The goal of Dodd-Frank preventing another meltdown has not been remotely achieved. Dodd-Frank is barely 60% written and what’s been put into place to safeguard the financial system from imploding and ruining the economy again is being challenged by academics and regulators as being unworkable. Dodd-Frank hasn’t already failed, that’s neo-conservative rhetoric. Mr. Kupiec would rather encourage expensive financial intermediation (for the sake of big banks profiteering) over financial stability. He’s got it backwards.

Dodd-Frank grants the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corp. and the Financial Stability Oversight Council vast new powers to regulate, with no checks on the exercise of these powers. Regulators are directed to exercise their new powers to ensure financial stability and mitigate systemic risk, but financial stability and systemic risk are never defined in the legislation.

Shah: One reason financial stability and systemic risks aren’t defined is that the rules and regulations are still being written. Another reason they’re not defined is that bankers don’t want them defined, they don’t want transparency into their inner workings. Mr Kupiec says, “Regulators are directed to exercise their new powers to ensure financial stability and mitigate systemic risk,” isn’t that the whole point?

Mr. Kupiec seems to worry that the Financial Stability Oversight Council (FSOC), whose members are supposedly the most-in-the-know heads of the country’s regulatory agencies, wouldn’t be up the task of determining which institutions actually pose a threat to the economy if they were to fail.

The ambiguity of the designation standard provides the FSOC with virtually unlimited discretion. For example, under what conditions should the consequences of failure be evaluated: when the firm fails in isolation, or when the firm fails in a recession during which many other financial institutions are also distressed? Two very different standards may generate very different FSOC conclusions, and yet Dodd-Frank is silent on the issue.

Shah: There is no ambiguity as Mr. Kupiec believes. He asks:

“Under what conditions should the consequences of failure be evaluated: when the firm fails in isolation, or when the firm fails in a recession during which many other financial institutions are also distressed?“

Shah: Who cares if a firm fails in isolation or in a recession along with other distressed institutions? A failure is a failure and any failure of any too-big-too-fail institution, by definition, is a threat in isolation and especially en masse to the system they’re all interconnected to. Dodd-Frank isn’t silent on the issue, Mr. Kupiec’s rhetoric is deafening.

Moreover, recent speeches by senior Federal Reserve officials suggest that they will push to use Dodd-Frank powers to extend the Fed’s ability to restrict financial investments and the use of short-term debt finance beyond the banking system to control the activities of shadow banks. The stated goal in each case is to prevent “bad” financial intermediation and promote financial stability. But in no case do any of the new rules recognize the cost on economic growth.

Shah: Mr. Kupiec wants us to consider the “cost on economic growth” of bad financial intermediation. Really? The cost is immeasurable once the damage is done. Bad financial intermediation is what Dodd-Frank is trying to address. No-one cares about plain vanilla, transparent lending with reserves and transparency. It’s the exotic intermediation conducted in the shadows, most of which are cast by big banks, that has to be considered.

It is easy to understand how the imbalances in the Dodd-Frank Act led to over-regulation. Regulators’ highest priority is ensuring that the financial system is stable; for them, slow or moderate economic growth is simply business as usual. But should a financial crisis arise, regulators would be disgraced. Dodd-Frank creates a clear bias encouraging over-regulation in the pursuit of financial stability because, for financial regulators, regulations are costless.

Shah: Apparently, we all don’t get it, “Dodd-Frank led (emphasis added) to over-regulation” and that’s why we have no economic growth. Who knew we were living in the past already? I also didn’t know that regulators ensuring financial system stability empowered them to simultaneously ratchet down economic growth (do they have a lever somewhere?) to their “business as usual” low-water mark.

Four years after the passage of Dodd-Frank, it is clear that Congress needs to revisit the legislation to prevent over-regulation in the pursuit of a single goal of financial stability. Dodd-Frank must be amended to require a balance of the following goals: financial stability, economic growth, and full employment. Otherwise, the economy will continue to get too much regulation and be short-changed on economic growth.

Shah: Mr. Kupiec’s closing paragraph speaks to the failure, not of regulators’ abilities to prevent economic catastrophes, they’ve certainly failed, but the failure of financial services institutions to safeguard their own businesses and the country from their greed-mongering. Congress needs to have Dodd-Frank legislation finished before it’s revisited midstream by lobbyists and the financial power elites who’ve commandeered once free markets and the country.

The Great Recession wasn’t caused by over-regulation; it was caused by over-leveraged financial intermediaries who hid their pyramid scheming from regulators.

As far as our slow recovery from that travesty, that has nothing to do with regulation, and everything to do with what inadequate regulation wrought…