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After every over-optimistic credit expansion comes the ensuing bust. After every bust, come legislation and expanded regulation to try to prevent the next crisis from happening-but it always happens anyway. For example, after the financial crises of the 1980s, we had the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the FDIC Improvement Act of 1991, and the very ironically named Federal Housing Enterprises Financial Safety and Soundness Act of 1992. It was predicted at the time that this would ensure we would “never again” have a financial crisis-a poor prediction, needless to say, including the fact that Fannie Mae and Freddie Mac proved to be the opposite of safe and sound.
After the corporate accounting scandals of 2001-2002, we had the Sarbanes-Oxley Act, which attempted, among other things, to ensure business risks were controlled by expanded rules and procedures. They obviously were not.
After the great housing bubble and the collapse of 2007-2009, we got the Dodd-Frank Act. It is my view that the greatly increased bureaucracy and regulation mandated by this act will not prevent another crisis-to know whether this is correct we have to await the unknowable future. However, it is certain and universally agreed that Dodd-Frank has and will continue to significantly expand the regulatory burden on financial businesses, including community banks. The disagreement is about whether this expanded burden is worth it or not. About this there are of course conflicting views-my view is that it is not, especially considering the negative effects on overall competition in financial services.
I believe the central question posed by this hearing is excellent-indeed we should be required to ask and answer about every regulation: What are its effects on competition?
As a general principle, if complex, expensive regulatory requirements are placed on all competitors, the burden will be disproportionately heavier for small competitors and large firms will be relatively advantaged. Large firms already have internal bureaucracies accustomed to complicated paperwork, reporting and regulatory relationships, the costs of which they spread over large business volumes. These economies of scale are not available to small competitors.
Congress recognized this general problem in Dodd-Frank itself, when it reduced the burden on small public companies of the notorious bureaucracy of Sarbanes-Oxley’s Section 404.
As Tom Hoenig (then-president of the Federal Reserve Bank of Kansas City and now a director of the FDIC) said, “Dodd-Frank has raised the cost of financial transactions in America and that encourages consolidation because it’s the only way you can spread the costs over larger assets.”
The CEO of M&T Bank, a well-managed regional bank, said last year that the paperwork of Dodd-Frank had so far required 18 full-time employees-that is before implementation of many other regulations now in some stage of development, including whatever the Consumer Financial Protection Bureau mandates, and before the arrival of the complicated new risk-based capital requirements. Compare this to the total staff of the median bank, 37 employees.
The complex new risk-based capital requirements, which are being applied to all banks, large and small, are an interesting case of the problem. Banking consultant Bert Ely concluded that “the highly granular features of many specific provisions in the regulatory capital proposal will mandate a substantial increase in the number of both financial and nonfinancial data items banks will have to collect on individual assets in order to generate the numbers. Data of the type now generally found in a bank’s accounting records will not be sufficient. Inadvertent compliance errors, when calculating capital ratios, will increase.” Ely speculates that these costs “could drive [smaller] banks to exit lines of business.”
It is not unreasonable to think that Dodd-Frank’s effects will impede the ability of small banks to raise capital. “Investors are concerned with a smaller bank’s ability to respond to regulatory obligations,” wrote the Conference of State Bank Examiners. “As investors vote with their money on the regulatory burden issue, policymakers should take notice that this is a very real issue with a potentially adverse economic impact.”
Regulation itself is one of the most important procyclical factors in credit markets-a problem well known to theoreticians of financial regulation. This is especially true in the down cycle, where we still are in housing finance, as the regulatory efflorescence mandated by Dodd-Frank continues. Reflecting each bust, including the most recent one, regulators, afraid of being criticized, seeing the depletion or disappearance of their deposit insurance fund, and reacting to the past mistakes now so apparent in hindsight, clamp down forcefully on banks, including refusing to charter new entrants which would bring unburdened new capital to the sector. This contracts credit further than the crisis already has, as we have once again experienced, this time in the residential mortgage market.
Community banks can be very successful managers of residential mortgage credit to their own customers in their own towns. A healthy, competitive residential mortgage sector, in my opinion, should feature mortgage credit risk widely dispersed among knowledgeable local lenders, who also have the ability to share credits among themselves.
What did the American GSE-centric mortgage system create instead? A duopoly system of Fannie and Freddie, with mortgage credit risk concentrated on the banks of the Potomac, a system once claimed in congressional testimony and elsewhere to be “the envy of the world.” The result was that Fannie and Freddie lost every penny of all the profits they had made in the 35 years from 1971 to 2006, plus another $150 billion. They have been transformed in substance from insolvent GSEs to government housing banks, but they are still there and more dominant than before in mortgage finance.
One of the most important competitive effects of Dodd-Frank results from a lack of action: its well-known failure to address the concentrated, duopoly system of Fannie and Freddie in any way. Thus concentration in the mortgage business and mortgage credit risk bearing continues and grows. Indeed, some people are now calling for Fannie and Freddie to be combined into a single mortgage securitizer-to turn their conforming mortgage duopoly into a monopoly. I do not favor this proposal.
In the mean time, all actors in the residential mortgage market, including the community banks, are involved in the continuing complex development of two mortgage regulations in particular, arising from the requirement of Dodd-Frank: the qualified mortgage and qualified residential mortgage rules. By establishing top-down formulas and escalating the legal risks to the lender of making mortgage loans, these regulations will certainly increase the burdens and reduce the role of local judgment in the mortgage business.
The QRM rule will determine whether mortgage competitors are required to retain credit risk in mortgages sold into securitizations-the “skin in the game” idea. I think having mortgage lenders retain credit risk in the loans they make, when they are paid for so being in the mortgage credit business, is an excellent idea-as long as the risk retention is a voluntary, market transaction.
The Dodd-Frank idea is not a voluntary market arrangement, but a mandatory and formulaic requirement. The better approach would be to facilitate and encourage mortgage credit risk retention by lenders, but not mandate it.
A notable and much-debated provision of Dodd-Frank is the designation of very large financial firms as SIFIs-Systemically Important Financial Institutions. What will the competitive effects of this be? SIFIs will be subject to special regulatory requirements and oversight-a burden. But on the other hand, this will cause them to be perceived as safer. Moreover, they will most probably benefit from being designated as of special interest and significance to the whole financial system and to the government.
Alex Pollock is resident fellow at the American Enterprise Institute.
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