“But no single human being, and probably not even the combined effort of thousands of them, seems able to clarify where you can draw a legal line between good banking and bad.”, Adam Davidson, Wall Street Journal Magazine
Wall Street Is Using the Power of Dodd-Frank Against Itself
Credit Illustration by Andrew Rae
Regulating Wall Street is an Old Testament sort of affair: Like Leviticus, it is all about the persnickety details. But politicians try to talk about it in New Testament terms, with sinners and saints, salvation and damnation. Only they can’t agree on who the sinners are — the bankers or the bureaucrats — and wherein lies salvation. Such moralizing, however, does very little to shine light on the benefits and drawbacks of the byzantine 2010 banking regulations known as Dodd-Frank.
Dodd-Frank is a sprawling piece of legislation, divided into 16 sections that together represent the most drastic change in financial regulation since the Great Depression. The law created multiple government bodies tasked with monitoring and intervening in financial markets. In the event of crisis, it stipulates new ways to dissolve large banks without requiring government bailouts. The law also created the Consumer Financial Protection Bureau, increases the regulation of hedge funds and does several thousand other things, big and small.
Nobody thinks Dodd-Frank is perfect, but there is a broad consensus on the political left that it shifted power, at least a little, from banks to consumers, and thereby made our economy slightly safer and fairer. I have heard plenty of people say that Wall Streeters and Republicans want to kill Dodd-Frank. I’m sure plenty of them do.
But what I’ve noticed since the law passed is not an effort to destroy it but one to — in a phrase borrowed from my junior-high karate teacher — use its power against itself. We can see evidence in the hundreds of meetings that banking regulators have had with industry groups, haggling over every tiny detail of the law. We can see it too in the numerous lawsuits filed by banks, financial-services companies and their advocates, which seem designed to lull anybody who mistakenly happened upon them to sleep. They call for subtle changes in the rule-making process, demand redefinition of financial instruments and in myriad other ways seek to change the letter of the law so as to alter its spirit.
At the heart of the battle between Dodd-Frank’s supporters and opponents is a deep uncertainty over what exactly banks are up to. We know we need banks. We also know that, in aggregate, banks took absurd risks before the financial crisis, which jeopardized our very way of life. But no single human being, and probably not even the combined effort of thousands of them, seems able to clarify where you can draw a legal line between good banking and bad.
In the middle of the crisis in late 2008, I turned in search of solace to an essay that Ben S. Bernanke wrote back in 1983, when he was not quite 30, and long before he would become the Fed chairman. Called “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression,” the paper revealed what the young Bernanke thought about the last time the American economy disintegrated. Everybody I knew in finance was talking about this paper and finding reassurance in its wisdom. They were thankful that he, of all people, was steering the ship. But I had a different reaction: The essay, for all its brilliance, filled me with dread.
In the early 1980s, Bernanke had sought to answer a seemingly simple question: Why did the Great Depression last so long? For a decade, unemployed people wanted to work. Owners of capital had money to pay them, and factories were sitting idle. What kept them apart? Bernanke’s answer was that banks had been the essential connection; under normal circumstances, they would link those with a surplus of money to those with a dearth.
Banks, at their best, perform a sort of financial magic. Consumers put their little bits of extra money in a savings account, expecting to be able to remove it whenever they’d like. Borrowers, though, often want to take out loans for years, even decades, to fund new businesses or buy homes. The fundamental role of banks is to transform short-term deposits into long-term debt. That is called financial intermediation and, without it, a modern economy ceases to function. (This is what the Treasury Department was seeking to avoid in 2008, by bailing out so many banks.) But the banks know we need them, and they use that fact to take more than they deserve. Banks — especially when they become large and complex — are at once essential and destructive, beneficial and insidious.
Credit Illustration by Andrew Rae
As I read Bernanke’s paper, I realized that when an industry becomes necessary for the proper functioning of our society, it wields an unhealthful amount of power. Specifically, it is in the perfect position to engage in what economists call “rent seeking.”
Generally speaking, businesses earn profits in one of two basic ways. The first is by providing goods and services more productively than others and selling them at a price people are willing to pay. The second is by seeking rents. “Rent,” in the economic sense, refers broadly to any excess benefits that people and businesses receive simply because they have power over something that others need. Patents are a form of rent, as are cable-TV monopolies.
For economists, rent-seeking is everywhere, and is a common way that economies go awry. Crudely speaking, productivity enhancement is good, because it makes society richer over all. Equally crudely, rent-seeking is bad, because it makes the people who are already rich even richer. Rent-seeking tends to be a force against innovation and for stagnancy, in large part because its focus is on the past — on maintaining power and influence gained long ago, often at the expense of innovation. Businesses built around rent-seeking don’t try to increase the size of the pie; they just want to make sure they get a bigger slice. (If a company doesn’t seem to care about your opinion of it as a customer, there’s a good chance that it is seeking rents.)
Between 2009 and 2011, a group of economists at New York University’s Stern School of Business published an influential series of reports and books that sought to explain what, exactly, happened during the financial crisis. The depth of the inquiry was notable because the school is generally thought of as a Wall Street-friendly training ground for future bankers. One of the most striking findings was that between 1980 and 2000, the large banks in America had significantly moved away from productivity enhancement and toward rent-seeking.
For the reports’ principal authors, Matthew Richardson and Viral Acharya, the evidence of this shift came from careful study of the various ways that banks have legally evaded regulation of their capital requirements. A fundamental tenet of bank regulation is that banks shouldn’t borrow too much, because being overleveraged makes them vulnerable to collapse. But banks can most easily make huge profits if they borrow huge amounts, and they tend to pursue unsafe levels of borrowing. Then, the authors observed, they use their power as essential tools in an economy to negotiate bailouts from the government, forcing taxpayers to guarantee their losses. Richardson and Acharya showed that it was precisely because our banking regulations were so extensive and complex that banks were able to seek rents. They called this “regulatory arbitrage,” a term that means banks have harnessed regulation and turned it into a powerful business tool.
The N.Y.U. research cuts against both the standard left- and right-leaning critiques of Wall Street. The perception of many on the left is that banks were once well regulated and then the oversight stopped. But banking regulation has in fact grown over the past 30 years, with more regulators enforcing more (and more complicated) rules. For many on the right, of course, this is itself the problem: All that government intrusion, they argue, is stifling the financial system. But Richardson and Acharya’s research shows that we’re in a scarier place than either side realizes. By freeing banks’ hands, reducing regulation might incentivize them to engage in more rent-seeking. But by increasing the complexity of the rules, overregulation can enable rent-seeking just as easily.
Even today, five years after its passage, Dodd-Frank is still an amorphous beast. But one thing is clear: Dodd-Frank does little to prevent or counteract the rent-seeking and regulatory arbitrage that have become the hallmarks of the 21st-century bank. To fight rent-seeking, we would need banking laws made up of straightforward rules that educated laypeople could understand. They would have to eliminate our maddeningly complex regulatory infrastructure. There would be trade-offs: The financial system might not perform as efficiently, and the economy might not grow as quickly during boom times. But if done right, an overhaul of banking regulations could create a political context in which rent-seeking self-enrichment by banks is no longer the norm. We might even come to call it what it is: corruption.
Adam Davidson is a founder of NPR’s “Planet Money” and a contributing writer for the magazine.
A version of this article appears in print on May 31, 2015, on page MM18 of the Sunday Magazine with the headline: Wall Street Is Using the Power of Dodd-Frank Against Itself.