The Case Against Dodd-Frank

deposit insurance, Dodd-Frank, emergency lending, FDIC, risk retention
Copies of the "The Case Against Dodd-Frank," edited by Norbert Michel, published by the Heritage Foundation.

The Case Against Dodd-FrankThe Heritage Foundation recently released a policy book, The Case Against Dodd-Frank: How the Consumer Protection Law Endangers Americans.  The book consists of a title-by-title examination of Dodd-Frank, with each book chapter more or less corresponding to one of Dodd-Frank’s titles.  CMFA’s Mark Calabria and Thaya Brook Knight both contributed, with Calabria writing on deposit insurance (Title III), payday lending (Title XII), and mortgage finance (Title XIV and Title IX Subtitle D).  Calabria and Knight co-wrote a chapter on credit rating agencies and executive compensation (Title XI).

The book is particularly helpful because of its “problems and solutions” format, dissecting the problems of a specific section or title of Dodd-Frank, and then offering a plan policymakers can take to revise it.  Of course, the solutions presented are second-best, at best.  In our legislative system, shrinking the size of the regulatory state is much more difficult than growing it.  When such beneficial shrinking does occur, it tends to be piecemeal.  The solutions posed here are attuned to this reality.

The book offers a convenient chapter-by-chapter summary in its introduction, along with 10 principles governing the authors’ reform proposals.  But let’s highlight a few topics of particular salience to Alt-M: deposit insurance, mortgage securitization provisions, and Federal Reserve emergency lending.

Deposit Insurance

What makes deposit insurance so destabilizing?  Mark Calabria argues that depositors have no incentive to closely scrutinize their bank’s capital holdings and investment activity.  Consequently, bank managers do not have to worry that excessive risk taking will drive them away.

One doesn’t have to be a limited government advocate to realize that deposit insurance harms bank stability.  Even President Franklin Roosevelt was a vocal opponent.  When considering the Glass-Steagall bill in 1933 that contained the FDIC, he commented that deposit insurance “would lead to laxity in bank management and carelessness on the part of both banker and depositor.”

Empirical evidence confirms the moral hazard problem of deposit insurance.  Comparing the Canadian versus American banking system in the 1920s and 30s, Calabria notes that the Canadian system, with no insurance, suffered only one failure, while the American system, with its state-based system of deposit insurance at the time, suffered 6,000 bank suspensions in the 1920s alone — the worst failures being in states with the most generous insurance systems.  A current World Bank study of 150 countries found that the more generous a country’s deposit insurance, the more frequent that country faced banking crises, all else equal.

Dodd-Frank is likely to expand the share of insured, relative to uninsured, deposits among banks by changing how FDIC fund premium payments are calculated.  Before Dodd-Frank, the premiums banks paid into the fund were based on the total amount of the bank’s liabilities covered by deposit insurance.  Now, the premiums are based on a formula: total assets minus total tangible equity.  The old formula encouraged banks to cautiously fund operations using debt or uninsured deposits; the new formula favors using insured deposits thereby “increasing moral hazard and placing the deposit insurance fund at ever greater risk.”

How can policymakers fix the mal-incentives of Dodd-Frank’s Section 331?  Calabria believes that the first step is reducing the deposit insurance cap from $250,000 to the pre-1980 limit of $40,000.  Given that the median dollar amount held in a U.S. checking account is $4,000 and the median for a certificate of deposit account is $16,000, federal insurance would still cover most depositors — a politically palatable proposition.  The reduced cap, however, would restore some market discipline by encouraging larger deposit holders to become more informed about where they place their funds.

Mortgage Finance

Calabria also writes sections on mortgage and housing policy.  A popular view after the crisis was that mortgage securitization allowed mortgage originators to make overly risky loans and then embed the risk deeper in the financial system via MBS.  But Calabria points out, the buildup in securitization in the decades preceding the crisis is better understood as regulatory arbitrage resulting from the Basel capital standards’ relatively low risk weight for mortgage debt.

To curb securitization, Subtitle D of Dodd Frank’s Title IX introduced a provision requiring mortgage issuers to maintain “not less than five percent of the credit risk” for any loan that fell outside of the newly created “qualified residential mortgage” (QRM) safe harbor.  While this provision, known as risk retention, won’t improve lending practices or financial stability, Calabria demonstrates that it will increase costs.

The provision that creates the QRM safe harbor standard is actually an amendment to the 1934 Securities Exchange Act, meaning that issuers of MBS retrospectively found to be containing non-QRM mortgages would be subject to the SEC rule 10b-5 prohibition against fraud.  This liability will “increase documentation and verification costs, which will ultimately be passed on to borrowers.”

Because Subtitle D of Title IX attaches “increased liability to any violation" of its mandated solutions for resolving conflicts of interest, rather than removing "artificial incentives for securitization,” Calabria favors a full repeal.  Short of that, he suggests creating a simpler standard for risk retention, requiring it only for pooled subprime mortgages.  Calabria also urges policymakers to reconsider the risk weight system actually responsible for encouraging excess investment in risky MBS.

Emergency Lending

Heritage's Norbert Michel covers Section XI of Dodd-Frank, which attempts to restrict the Fed’s emergency lending powers.  Michel shows how the Fed has consistently abused both the discount window and Section 13(3) emergency lending, issuing loans not justified by Bagehot’s classic lender of last resort principles.

In 1974, the Fed provided six months worth of discount window loans to the failed Franklin National Bank.  In 1985, it lent to the failed Continental Illinois for a full year.  Of the 530 depository institutions that failed from 1985-1991, sixty percent had outstanding discount window loans, valued at $8 billion in total.  Of course, the largest instances of questionable Fed lending occurred during the recent crisis.  The Fed lent $16 trillion; generally at below market rates, against suspect collateral, and to firms of questionable solvency.  According to Michel, the Fed served as a “source of subsidized capital,” rather than a true last resort lender.

Section XI of Dodd-Frank amended 13(3) to allow emergency loans only if such loans had “broad based eligibility,” and to prohibit such loans from being extended to insolvent borrowers.  Unfortunately, Dodd-Frank lets the Board of Governors make the rules defining “broad based” and “insolvent,” and their definitions do not amount to much of a restriction. Instead, Michel proposes both revoking Section 13(3) and closing the discount window entirely, to restrict Fed lending to broadly accessible open markets operations (OMO) only. As a complement, Michel advocates ending the primary dealer system, allowing all Fed member banks to directly participate in OMO, further ensuring Fed policymaking does not serve as de-facto preferred credit allocation.

Again, find complete online text of The Case Against Dodd-Frank here.  And you can also check out a special event with several of the book’s authors next week at The Heritage Foundation; registration and live stream info here.