Financial Reform Is Working
March 7, 2016
The critics of the financial reform Dodd-Frank Act are fond of saying that it doesn’t work—some going so far as to say that the financial system is just as much at risk as it was in 2008, if not even more so.
We used to joke with them, “Of course Dodd-Frank is working: after all, we haven’t had a financial crash since it was enacted in 2010.” It was an easy joke to make: after the 2008 financial crisis and the Great Recession, there wasn’t much appetite or ability for outsized risk-taking or speculation. As a result, the U.S. economy and financial system simply hasn’t faced the kinds of risks that it did in 2008.
But now, there is stress and distress in the global economy and financial systems. In many ways, we are witnessing a live real-time test of the new financial rules.
Investors are spooked by plunging oil prices and significant stock market volatility, often in the same day. Market analysts and pundits are competing with each other to identify the “next financial crisis,” and they have eagerly pointed to negative interest rates, possible deflation, and a slowdown in the Chinese economy.
Some think that growing student debt will be the next “subprime crisis.” Others think that it will be trouble in the leveraged loan market, or a stampede for the exits when investors in fixed-income funds decide they want out. And troubles in the Eurozone are a perennial favorite.
Yet there is one obvious suspect that no one is pointing to: the too-big-to-fail systemically important financial institutions that are based in the United States—the so-called “SIFIs” which were at the core of causing and spreading the 2008 financial crash.
Currently, there are no runs on these institutions. Their bondholders do not seem to be particularly worried that they will lose money. There have been no Jim Cramer-like pleas for the Federal Reserve to open the checkbook and inundate the financial system with emergency liquidity. In fact, some think that now is a good time to buy bank stock.
No question, these are tough times and the economy and financial systems in the world are under some serious pressures. But it is singularly noteworthy that U.S. SIFIs seem to be holding up quite well so far. While no one is saying it, the financial rules implemented under the Dodd-Frank Act are the reason.
Just look at the changes that have happened in the five years since the Dodd-Frank Act was signed into law:
• the SIFIS are much better capitalized than they were before the financial crisis—their capital has doubled, which means that they are better able to withstand losses without failing or turning to the taxpayer or the Fed for a bailout.
• the SIFIs have much greater liquidity than they did before the financial crisis—they have three times the liquidity that they did, which means that they meet demands for cash without having to resort to asset firesales to pay off their creditors.
• the SIFIS are now clearing their derivatives trades through central clearing houses, which helps mitigate the risk that any one SIFI is building up an unknown unmanageable exposure.
• the SIFIs are now posting collateral against their derivatives trades, which helps limit the leverage that these institutions can build up through these instruments.
• the SIFIs are not permitted to engage in proprietary trading and must limit investments in hedge funds due to the Volcker Rule restrictions, which means that they couldn’t load up their balance sheets with energy and related risks that are blowing up at other financial firms.
• the SIFIs have been subjected to rigorous stress-testing by the Federal Reserve, which required them to demonstrate that they had the resilience to withstand shocks and stresses similar to what we’re seeing now.
• the SIFIs have “living wills” in place, which, while inadequate, have forced them to think about becoming less complex and better organized and to demonstrate to the regulators that they could be wound down without requiring government bailouts or jeopardizing the financial system.
Yes, that’s not enough and more needs to be done, but it simply cannot be denied that the U.S. financial system and its biggest SIFIs are stronger and more resilient than they were in 2008, thanks to the rules the Dodd-Frank Act required. And, notwithstanding all those rules and Wall Street’s claims that they would have a crushing burden on them, bank profits rose by 11.9 percent in the fourth quarter from a year earlier to $40.8 billion - in just one quarter!
None of that is to suggest that the battle for financial reform is over, that Dodd Frank has been fully and effectively implemented, or that it’s time to declare victory over financial crises. Even though the SIFIs are safer thanks to the Dodd-Frank Act, these same institutions have fought—and they continue to fight—the regulators’ efforts to finish the Dodd-Frank Act rules and then implement and enforce them.
And it may well be that before the jobs, homes, savings and livelihoods of all Americans are truly protected from the next financial crisis, we may need comprehensive structural reforms, like size caps on the biggest banks, re-instating Glass-Steagall or even breaking up the largest banks. (Minneapolis Fed President Neel Kashkari has recently talked about the need to do just that.)
But in the meantime, we should realize that all of us—including the too-big-to-fail banks themselves—can breathe a little easier in this stressful environment, thanks to the Dodd-Frank Act.
This article first appeared on the Huffington Post here.