The Impact of the Dodd-Frank Act on Financial Stability ...

The Impact of the Dodd-Frank Act on Financial Stability and Economic Growth

Martin Neil Baily (Brookings) and Aaron David Klein (Bipartisan Policy Center), presentation to the University of Michigan Conference, October 24, 2014

A framework for assessing Dodd-Frank

The goal of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was to increase financial stability to ensure that there would never be a repeat of the crisis of 2007-2009.

We divide Dodd-Frank's provisions into five sets, those that have:

? Improved stability with positive impacts on both efficiency and economic

growth or with strong impacts on stability with minimal impact on economic growth (clear wins)

? Decreased financial stability without benefitting economic growth (clear

losses)

? Achieved little increase in stability at considerable cost to efficiency and

economic growth (costly trade-offs)

? Failed to adequately address a stability problem (didn't go far enough) ? Created an uncertain trade-off between financial stability and economic

growth (too soon to tell)

A framework for assessing Dodd-Frank

How regulators can make the most of Dodd-Frank In addition to laying out a taxonomy of key Dodd-Frank provisions, the authors suggest actions that could improve regulatory impact. These changes could be made by regulators within the scope of current legal authority.

How Congress can make Dodd-Frank better The authors support Dodd-Frank but believe that improvements should be made. There is a danger that re-opening the bill will result in gutting its main provisions, but there is also an opportunity for Congress to work with the president on reforms that both parties can accept. Repeal is neither desirable nor any longer practicable.

Clear wins: Increased capital

Pre-crisis problem: The largest banks had far too little capital Solution: Increased capital requirements have led to sharply increased capital levels. Capital increased from DFA but also Basel III and market forces.

'Big Six' - Average Tier 1 Capital Ratio

2007 (IV)

Tier 1 Capital / Total Risk-Weighted Assets (%)

5 6 7 8 9 10 11 12 13 14 15

2000

2005

2010

2015

Note: Unweighted average of the Tier 1 risk-based capital ratios of JP Morgan, Citi, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley; Goldman Sachs and Morgan Stanley only began reporting as of 2009

Source: Federal Reserve Board Y-9C data

Clear wins: A new resolution process via the FDIC's single-point-of-entry strategy

Pre-crisis problem: Bailout or instability A major problem in the crisis was that policymakers were faced with the choice of either bailing out large institutions or letting them go under, with serious consequences for financial stability.

Solution: Dodd-Frank Title II Resolution Regime as implemented by the FDIC under the single-point-of-entry strategy (SPOE) Under SPOE, SIFI banks must create a buffer of equity and long-term unsecured debt at the holding company level. In the event of a failure, the holding company is lifted off while the subsidiaries are placed into a "Newco" (bridge company) and remain in operation.

Clear wins: A new resolution process via the FDIC's single-point-of-entry strategy

Benefits of SPOE

? The costs of failure are borne by the equity and long-term debt holders

of the failing institution. This solves the need for a taxpayer bailout while preserving stability. Newco will be solvent provided the buffer is large enough, but it will require liquidity support from the Fed or the FDIC. The FDIC is granted that authority in Dodd-Frank under Orderly Liquidation Authority while Newco should be able to access the Fed's routine liquidity features (e.g., the discount window).

? Foreign subsidiaries continue to operate, making cross-border issues

much easier to deal with.

? The approach has considerable international support, with cross-border

agreements reached with the UK and Canada, and has working relationships with Japan, the EU, Germany, China, and Switzerland. There is some resistance from countries that do not want to allow their large banks to fail.

Clear wins: Creation of the CFPB

Pre-crisis problem: Consumer financial protection took a back seat Bifurcated regulatory authority, limited regulatory will, and a lack of legal authority to regulate non-bank consumer products led to substandard consumer protections in many parts of the country. Consumers were abused in the mortgage, credit card, small-dollar lending, and other markets.

Solution: Consolidate consumer protection in one agency with expanded jurisdiction to create a level playing field The Consumer Financial Protection Bureau (CFPB) was created with a single mission to focus on consumer protection. Authority was realigned and expanded to cover most major consumer products. Independent funding was secured along with very competent senior leadership. The agency was successfully launched and has been actively engaged.

Clear wins: Creation of the CFPB

Assessing the Bureau after four years

The CFPB quickly established itself as a major financial regulator. The Bureau has engaged both bank and non-bank lenders, consumers, and policy makers in tackling a range of critical issues. It is hard to think of any new federal regulatory agency that has had as much impact in its first few years.

The new process creates difficulty across regulators. The CFPB's product-based examination process challenges traditional bank regulators and institutions who were used to entity based regulation. Bank regulators struggle to integrate CFPB findings into their holistic examination process, while the Bureau is still working to best determine how to close out examinations. Tension at inception is healthy, but regulators must ultimately work cooperatively to avoid regulatory gaps and frictions.

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