Introduction to Prosperity Unleashed

Introduction to Prosperity Unleashed

Prosperity Unleashed: Smarter Financial Regulation provides solutions to the core regulatory problems that have existed in U.S. financial markets for decades. Policymakers can implement these solutions to make U.S. financial markets more dynamic, resilient, equitable, and accountable than ever before. Policymakers should implement these solutions because a well-functioning financial sector results in a society with more goods and services, more employment opportunities, and higher incomes. A smoothly running financial system makes it easier and less costly to raise the capital necessary for launching or operating a business, to borrow money for buying or building a home, and to invest in ideas that improve productivity and increase wealth.

Financial enterprises are the arteries through which money from one sector of the economy flows into others, creating jobs and wealth in the process. Just as with nonfinancial businesses, excessive government regulation disrupts that smooth functioning, preventing financial firms from serving the needs of their customers and society. Despite these disruptions, policymakers have long treated financial companies differently than nonfinancial businesses. In particular, government policies have—for decades—empowered regulators to manage private risks and mitigate private losses in an effort to prevent financial-sector turmoil from spreading to the rest of the economy. This approach, rarely contemplated in nonfinancial industries, has demonstrably failed.

The 2008 financial crisis is an obvious example of a poorly functioning financial sector. Financial firms funded too much unsustainable activity largely because of the rules and regulations they faced, including the widespread expectation that the federal government would provide assistance to mitigate losses. Yet, the dominant narrative that supported passage of Dodd–Frank in 2010 was that deregulation in financial markets, beginning in the 1990s, caused the crash. Ostensibly, the unbridled pursuit of profits by “Wall Street” drove the global financial system to the brink of collapse. But this story is wrong. There was no substantial reduction in the scale or scope of financial regulations in the U.S. Rather, the sheer number of financial regulations steadily increased after 1999, long before Dodd–Frank was even contemplated.

Financial firms—not just banks—have long dealt with capital rules, liquidity rules, disclosure rules, leverage rules, special exemptions for rules, and the constant threat that regulators would make up new rules or enforce old rules differently. There is no doubt that, for decades, the U.S. regulatory framework has increasingly made it more difficult to create and maintain jobs and businesses that benefit Americans. One of the main reasons the regulatory regime has been counterproductive for so long is because it seeks to micromanage people’s financial risk, a process that substitutes regulators’ judgments for those of private investors. This approach provides a false sense of security because the government confers an aura of safety on all firms that play by the rules, and it is bound to fail for at least three reasons: (1) people take on more risk than they would in the absence of such rules; (2) people have lower incentives to monitor financial risks than they would otherwise; and (3) compared to other actors in the market, regulators do not have superior knowledge of future risks.

In addition to these shortcomings, the U.S. regulatory framework, for at least a century, has repeatedly protected incumbent firms from new competition—the very market forces that drive innovation, lower prices, and prevent excessive risk-taking. The result is that entrepreneurs have suffered from fewer opportunities, and consumers have suffered from fewer choices, higher prices, and less knowledge regarding financial risks. When the system crashes, as it has done on several occasions, people naturally tend to blame the excesses in the private sector while giving the government more power to stabilize the economy. In the end, this process is a perverse self-reinforcing cycle that fails to make the economy any safer as it chips away at economic freedom and the prosperity it fosters.

Prosperity Unleashed shows how to reverse these trends, so that financial markets will expand economic opportunities and help people achieve financial security. Many authors of this volume recently contributed to The Case Against Dodd–Frank: How the “Consumer Protection” Law Endangers Americans. That book exposed the many flaws in the Dodd–Frank Wall Street Reform and Consumer Protection Act, but it also revealed the gross inadequacy of the financial regulatory framework that existed prior to Dodd–Frank. It is clear that even if Congress repealed Dodd–Frank in its entirety, a highly flawed regulatory structure that weakened financial markets and contributed mightily to the 2008 financial crisis would still remain. Solving America’s core regulatory problems in order to expand economic opportunities and help people achieve financial security is the goal of Prosperity Unleashed.

While each chapter expresses the views of its authors, each is based, as appropriate, on the following 10 core principles—also included in The Case Against Dodd–Frank—about the financial system and how best to regulate it.

Ten Core Principles

  1. Private and competitive financial markets are essential for healthy economic growth.
  2. The government should not interfere with the financial choices of market participants, including consumers, investors, and uninsured financial firms. Regulators should focus on protecting individuals and firms from fraud and violations of contractual rights.
  3. Market discipline is a better regulator of financial risk than government regulation.
  4. Financial firms should be permitted to fail, just as other firms do. Government should not “save” participants from failure because doing so impedes the ability of markets to direct resources to their highest and best use.
  5. Speculation and risk-taking are what make markets operate. Interference by regulators attempting to mitigate risks hinders the effective operation of markets.
  6. Government should not make credit and capital allocation decisions.
  7. The cost of financial firm failures should be borne by managers, equity-holders, and creditors, not by taxpayers.
  8. Simple rules—such as straightforward equity capital requirements—are preferable to complex rules that permit regulators to micromanage markets.
  9. Public-private partnerships create financial instability because they create rent-seeking opportunities and misalign incentives.
  10. Government backing for financial activities, such as classifying certain firms or activities as “systemically important,” inevitably leads to government bailouts.

Summaries of Arguments

The chapters in Prosperity Unleashed include an expansive list of reforms in both the banking and securities markets, including structural changes to government regulators, improvements to self-regulatory organizations, and better ways for the government to deter fraud. Prosperity Unleashed even includes detailed policy reforms to end government preferences, such as federal loan guarantees, bankruptcy protections for derivatives, and emergency lending by the Federal Reserve. This introductory section includes a brief list of the arguments in each section of the book.

Part I. Banking Regulation Reforms

In chapter 1, “Deposit Insurance, Bank Resolution, and Market Discipline,” Mark Calabria explains how government-backed deposit insurance weakens market discipline, increases moral hazard, and leads to higher financial risk than the economy would have otherwise, thus weakening the banking system as a whole.

  • Deposit insurance does not primarily benefit low-income and middle-income families. The top 10 percent of households hold 67 percent of all deposits, and the current Federal Deposit Insurance Corporation (FDIC) deposit insurance limit is $250,000 even though the average account balance is less than $5,000.
  • The public interest would be best served if Congress reduced federal deposit insurance coverage to the pre–savings-and-loan-crisis limit of $40,000, and provided coverage on a per individual basis.
  • To further the goal of reducing systemic risk, Congress should also limit the total deposit insurance coverage of any one bank to 5 percent of total insured deposits.
  • Bank receivership, as practiced by the FDIC, is inappropriate for non-banks, and weakens market discipline by occasionally protecting uninsured creditors.
  • Ultimately, government-provided deposit insurance should be phased out fully. In the interim, coverage should be reduced to more closely align with protecting small retail investors.


In chapter 2, “A Simple Proposal to Recapitalize the U.S. Banking System,” Kevin Dowd follows with a brief look at the failure of the Basel rules and a discussion of how banks’ historical capital ratios—a key measure of bank safety—have fallen as regulations have increased. Dowd proposes a regulatory off-ramp, whereby banks could opt out of the current regulatory framework in return for meeting a minimum leverage ratio of at least 20 percent.

  • Instead of proposing more regulation or idealistic reforms, it could be more useful to propose a regulatory off-ramp: Banks would be allowed to opt out of prudential regulation, provided they maintain high capital standards.
  • Banks with good prospects could raise capital on the stock market and thereby escape the regulatory system. They could greatly cut costs and improve their competitiveness.
  • Zombie banks would be unable to meet these higher capital standards and would self-advertise their true status.
  • Over time, the good banks could gradually displace the bad ones, and the whole prudential regulatory apparatus would wither on the vine.

Diane Katz’s chapter, “A Better Path for Mortgage Regulation,” provides a brief history of federal mortgage regulation. Katz shows that, prior to Dodd–Frank, the preferred federal policy was to protect mortgage borrowers through mandatory disclosure as opposed to directly regulating the content of mortgage agreements. Katz argues that the vibrancy of the mortgage market has suffered because the basic disclosure approach has succumbed to regulation via content restrictions.

  • Deference to consumer autonomy is now largely defunct. Instead we have a framework of mortgage regulation that treats consumers as fundamentally irrational and prone to act against their self-interest.
  • This approach is inherently contradictory. If consumers suffer cognitive limitations with respect to mortgage matters, the politicians and bureaucrats who dictate the borrowing terms for consumers must also be afflicted by the same limitations.
  • Much of the reckless lending that played a role in the 2008 crisis resulted from lenders and borrowers responding—rationally—to incentives created by an array of deeply flawed government policies implemented years before the meltdown.
  • The best consumer protection for mortgage borrowers is a vibrant and competitive private mortgage lending market. Federal content restrictions on mortgages are directly counter to such an environment.

Norbert J. Michel’s chapter, “Money and Banking Provisions in the 2016 Financial CHOICE Act: A Major Step Toward Financial Security,” completes the first section of the book. Given that the Trump Administration has pledged to dismantle Dodd–Frank, Prosperity Unleashed’s banking reform section would be incomplete without discussing the reforms in the CHOICE Act, the first major piece of legislation written to replace large portions of Dodd–Frank. Michel discusses the CHOICE Act’s regulatory off-ramp—and one potential alternative—because a similar approach could be used to implement a broad set of bank regulation reforms.

  • The 2016 Financial CHOICE Act would replace large parts of the harmful 2010 Dodd–Frank Act, and provide regulatory relief for banks that choose to hold higher equity capital.
  • The act’s capital-election provision is a regulatory off-ramp that exempts banks from onerous regulations if they meet a higher capital ratio. There is little justification for heavily regulating firms that absorb their own financial risks—and higher capitalized banks do exactly that, lowering the likelihood of taxpayer bailouts.
  • The CHOICE Act’s capital election provides statutory language that could be modified to implement similar reforms described in two other chapters in Prosperity Unleashed.

Part II. Securities Regulation Reforms

In chapter 5, “Securities Disclosure Reform,” David R. Burton delves into the law and economics of mandatory disclosure requirements, both in connection with new securities offerings and ongoing disclosure obligations. Burton explains that disclosure requirements have become so voluminous that they obfuscate rather than inform, making it more difficult for investors to find relevant information.

  • The current securities disclosure regime has a substantial adverse impact on entrepreneurship, innovation, and economic growth.
  • Reasonable, scaled mandatory disclosure requirements have a positive economic effect. Aspects of the current securities disclosure regime harm, rather than help, investors.
  • Because the benefits of mandatory disclosure are so much smaller than usually assumed, policymakers should adopt a more skeptical posture toward the existing disclosure regime. Fundamental reform would dramatically reduce the complexity and regulatory burden of the current system and enhance investor protection.
  • Substantial improvements to Regulation A, Regulation Crowdfunding, Regulation D, and the regulation of public companies are required to improve the current system.
  • The existing rules contain at least 14 different categories of firms issuing securities, each with a different set of exemption and disclosure rules. These categories can easily be replaced with three disclosure regimes—public, quasi-public, and private. Disclosure under the first two categories should be scaled based on either public float or the number of beneficial shareholders.

Rutheford B. Campbell Jr. follows with “The Case for Federal Pre-Emption of State Blue Sky Laws,” a chapter that recommends improving the efficiency and effectiveness of capital markets through federal pre-emption of certain state securities laws. In particular, Campbell calls for pre-emption of state blue sky laws through which states impose registration requirements on firms issuing securities.

  • The two broad types of capital formation rules imposed by society—antifraud rules and rules requiring registration—incentivize the efficient disclosure of accurate, material investment information in connection with the offer and sale of securities.
  • These societal rules may, however, generate additional costs for the business that is seeking external capital. The additional costs may retard, or in some cases completely choke off, the flow of capital from investors to businesses.
  • There are obvious and significant increased costs generated as a result of imposing multiple registration regimes on businesses soliciting capital. Although Congress has to an extent pre-empted the registration requirements of state blue sky laws, the federal pre-emption is largely incomplete.
  • Most important is the fact that the pre-emption so far offers scant relief to small businesses when they search for external capital.
  • The federal government should completely pre-empt state authority over the registration of securities. Society needs a single set of efficient rules governing the registration of securities.

Next, in chapter 7, Daniel Gallagher tackles the seemingly opaque topic of U.S. equity market structure. Gallagher’s chapter, “How to Reform Equity Market Structure: Eliminate 'Reg NMS' and Build Venture Exchanges,” argues that the increasingly fragmented structure of today’s equities markets has been shaped as much, if not more, by legislative and regulatory action than by the private sector. Gallagher calls on the Securities and Exchange Commission (SEC) to consider rescinding Reg NMS and replacing it with rules (and rigorous disclosure requirements) that allow free and competitive markets to dictate much of market structure.

  • The SEC should immediately conduct a holistic equity-market-structure review that acknowledges and addresses the role that legislation and regulation have played in developing the structure of today’s markets. The SEC’s review should inevitably result in recommendations to Congress on how to update or eliminate vestigial statutory provisions.
  • In particular, Congress and the SEC should review: (1) the continued utility of Reg NMS and ways to return to a competitive market focused on all best-execution considerations; (2) the trading ecosystem for small-cap stocks and the establishment of venture exchanges; and (3) the proper governance of self-regulatory organizations (SROs).
  • The SEC should consider rescinding Reg NMS and replacing it with rules that allow free and competitive markets to dictate much of market structure with rigorous disclosure requirements.
  • Congress should enact legislation creating venture exchanges. This legislation should allow market surveillance obligations, SEC oversight, and price transparency for venture exchanges, but also reduced listing standards and regulatory filing requirements. Shares traded on these exchanges would be exempt from state blue sky registration, and the exchanges themselves would be exempt from the SEC’s national market system and unlisted trading privileges rules, so as to concentrate liquidity in these venues.

David Burton contributes the final chapter for this section: “Reforming FINRA.” Burton writes that FINRA, the primary regulator of broker-dealers, is neither a true self-regulatory organization nor a government agency, and that FINRA is largely unaccountable to the industry or to the public. The chapter broadly outlines alternative approaches that Congress and the regulators can take to fix these problems, and it recommends specific reforms to FINRA’s rule-making and arbitration process.

  • FINRA is a regulator of central importance to the functioning of U.S. capital markets. It is neither a true self-regulatory organization nor a government agency.
  • FINRA does not provide the due process, transparency, and regulatory-review protections normally associated with regulators, and its arbitration process is flawed. Reforms are necessary.
  • FINRA arbitrators should be required to make findings of fact based on the evidentiary record, and to demonstrate how those facts led to the award given. These written FINRA arbitration decisions should be subject to SEC review and limited judicial review.
  • FINRA rules have played a key role in the decline in the number of small broker-dealers. This has an adverse impact on entrepreneurial capital formation.
  • Congress and the SEC need to provide greater oversight of FINRA.

Part III. Regulatory Agency Structure Reforms

The first chapter in this section, “Reforming the Financial Regulators,” is coauthored by Mark Calabria, Norbert J. Michel, and Hester Peirce. The chapter argues that financial regulation should establish a framework for financial institutions based on their ability to serve consumers, investors, and Main Street companies. This view is starkly at odds with the current macroprudential trend in regulation, which places governmental regulators—with their purportedly greater understanding of the financial system—at the top of the decision-making chain.

  • There is no perfect structure for the financial regulatory system, but design affects how well regulation is carried out, so regulatory re-designers should proceed with care.
  • The current trend of regulatory homogenization—the shift toward uniform bank-centric regulation implemented by one “super regulator” at the international level—threatens to impair the effective functioning of the financial system.
  • Regulatory reform is needed, and it should be rooted in a recognition that financial market participants and their regulators respond to incentives in the same way that participants in other markets respond.
  • Greater accountability can be introduced, for example, by subjecting financial regulators to appropriations and implementing a commission governing structure.
  • Other key reforms include consolidating related powers in one regulator, removing authorities from agencies ill-equipped to perform them, and revamping processes to ensure appropriate accountability for, and public input in, rule-making.

In chapter 10, “The World After Chevron,” Paul J. Larkin, Jr., discusses the Supreme Court’s decision in Chevron U.S.A. Inc. v. Natural Resources Defense Council, a case that has generated considerable controversy among policymakers over the past decade. The Chevron decision effectively transferred final interpretive authority from the courts to the agencies in any case where Congress did not itself answer the precise dispute. Reform-minded policymakers have long called on Congress to return that ultimate decision-making authority to the federal courts.

  • The Supreme Court’s decision in Chevron U.S.A. Inc. v. Natural Resources Defense Council adopted a two-step test to decide whether an administrative agency had correctly interpreted a statute: Did Congress resolve the particular dispute at issue in the relevant law, and is the agency’s interpretation a reasonable one?
  • Members of Congress and many scholars believe that Chevron improperly delegated the courts’ responsibility to “say what the law is” to unelected members of the administrative state, and they have introduced legislation to overrule Chevron or have urged the Supreme Court to do so.
  • Overturning Chevron would return final decision-making authority to the federal courts, but it would not eliminate the influence of administrative agencies. A consistent, long-standing interpretation of a statute governing a technical field will likely always persuade the courts because they will conclude that the agency has figured out what is in the public interest.

Thaya Brook Knight’s chapter, “Transparency and Accountability at the SEC and at FINRA,” completes this section of the book. Knight describes how these two regulatory bodies—the two mostly responsible for governing the U.S. securities sector—lack the structural safeguards necessary to ensure that they exercise their authority with the consent of the American public. The chapter provides recommendations for fixing these deficiencies, such as giving respondents a choice of federal court or administrative proceedings with the SEC, and allowing FINRA to exist as a purely voluntary, private industry association.

  • The SEC’s administrative judges have acquired power to rival Article III federal judges, but administrative hearings lack the safeguards that define due process in the courts.
  • Those facing an SEC enforcement action should have the same opportunity the government lawyers have to choose between a trial in federal court and an administrative hearing.
  • FINRA’s quasi-governmental status lacks necessary checks on its power. The solution is to remove FINRA’s special status and make it a purely private organization.

Part IV. Government Preference Reforms

Diane Katz’s chapter, “The Massive Federal Credit Racket,” leads off the section by providing an extensive list of the more than 150 federal credit programs that provide some form of government backing. These programs consist of direct loans and loan guarantees for housing, agriculture, energy, education, transportation, infrastructure, exporting, and small businesses, as well as insurance programs to cover bank and credit union deposits, pensions, flood damage, crop damage, and acts of terrorism. Government financing programs are often sold to the public as economic imperatives, particularly during downturns, but they are instruments of redistributive policies that mainly benefit those with the most political influence rather than those with the greatest need.

  • Collectively, Americans shoulder more than $18 trillion in total debt exposure.
  • Total outstanding loans and loan guarantees backed by taxpayers exceeded $3.4 trillion at the end of fiscal year 2015.
  • Taxpayer exposure from Fannie Mae, Freddie Mac, the Federal Home Loan Banks, the Federal Deposit Insurance Corporation, and the Pension Benefit Guarantee Corporation exceeds $14 trillion.
  • Default rates exceeding 20 percent are common among federal credit programs. Federal accounting methods substantially understate the costs of credit subsidies.
  • Trillions of dollars of credit subsidies represent the commandeering of financial services by government and its escalating power over private enterprise.
  • This redistribution of taxpayers’ money erodes the nation’s entrepreneurial spirit, increases financial risk, and fosters cronyism and corruption. It is time to shut it down.

In “Reforming Last-Resort Lending: The Flexible Open-Market Alternative,” George Selgin proposes a plan to reform the Federal Reserve’s means for preserving liquidity for financial as well as nonfinancial firms, especially during financial emergencies, but also in normal times. Selgin proposes, among other things, to replace the existing Fed framework with a single standing (as opposed to temporary) facility to meet extraordinary as well as ordinary liquidity needs as they arise. The goal is to eliminate the need for ad hoc changes in the rules governing the lending facility, or for special Fed, Treasury, or congressional action. Among other things, the plan would:

  • Make Fed lending to insolvent, or potentially insolvent, institutions both unlikely and unnecessary, no matter how “systemically important” they may be, by allowing most financial enterprises to take part directly in the Fed’s ordinary credit auctions.
  • Dispense with any need for direct lending, including both discount window and 13(3) loans, whether aimed at particular institutions or at entire industries, and otherwise radically simplify existing emergency lending provisions of the Federal Reserve Act.
  • Eliminate any general risk of Fed mispricing or misallocation of credit, including such underpricing as might create a moral hazard.
  • Replace the ad hoc and arbitrary use of open-market operations to favor specific firms or security markets with a “neutral” approach to emergency liquidity provision, by making the same facility and terms available to a wide set of counterparties possessing different sorts of collateral.
  • Enhance the effectiveness of the Fed’s open-market purchases during periods of financial distress by automatically providing for extraordinary Fed purchases of less-liquid financial assets.
  • Eliminate uncertainty regarding the availability of emergency credit, and the rules governing its provision.

In chapter 14, “Simple, Sensible Reforms for Housing Finance,” Arnold Kling advocates establishing a national title database to prevent the sort of clerical errors that plagued the foreclosure process during the housing crash of 2007 to 2009. Kling also recommends eliminating government support for all mortgages with low down payments, and for refinancing loans that increase the borrower’s mortgage debt. Both types of loans encourage households to take on debt rather than accumulate wealth.

  • Immediately stop purchases by government agencies of mortgages that are for non-owner-occupied homes.
  • Immediately stop purchases by government agencies of mortgages for “cash-out” refinances.
  • Change risk-based capital regulations to assign 100 percent risk weight to mortgages for non-owner-occupied homes and for mortgages that are cash-out refinances.
  • Adopt a national title database in order to eliminate the requirement for title insurance.
  • Gradually phase out Freddie Mac and Fannie Mae by decreasing their loan limits.

In the second housing finance chapter, “A Pathway to Shutting Down the Federal Housing Finance Enterprises,” John Ligon provides an overview of all the federal housing finance enterprises and argues that Congress should end these failed experiments. The federal housing finance enterprises, cobbled together over the last century, today cover more than $6 trillion (60 percent) of the outstanding single-family residential mortgage debt in the U.S. Over time, the policies implemented through these enterprises have inflated home prices, led to unsustainable levels of mortgage debt for millions of people, cost federal taxpayers hundreds of billions of dollars in bailouts, and undermined the resilience of the housing finance system.

  • Over the past 80 years, Congress has assembled a system of federal housing finance enterprises (FHFEs), which have led to the deterioration of credit underwriting standards and encouraged imprudent risk-taking in the housing finance system.
  • FHFEs encompass the Federal Housing Administration, the Rural Housing Service, Ginnie Mae, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
  • FHFEs are antithetical to a free market in housing finance, and have led to less discipline by market participants. FHFEs create moral-hazard dilemmas that put homeowners, taxpayers, and private shareholders at greater risk of financial loss, while increasing home prices relative to what they would be otherwise.
  • FHFEs have encouraged an explosion of mortgage debt over the past several decades, while national homeownership is at the lowest rate since the mid-1960s.
  • It is time to shut down these FHFEs.

In the final chapter of this section, “Fixing the Regulatory Framework for Derivatives,” Norbert J. Michel discusses government preferences for derivatives and repurchase agreements (repos)—an often ignored but integral part of the many policy problems that contributed to the 2008 crisis. The main problem with the pre-crisis regulatory structure for derivatives and repos was that the bankruptcy code included special exemptions (safe harbors) for these financial contracts. The safe harbors were justified on the grounds that they would prevent systemic financial problems, a theory that proved false in 2008.

  • There is no objective economic reason to regulate derivatives or repurchase agreements (repos) as unique products. Financial institutions can best account for the risk of these instruments within their existing regulatory capital frameworks.
  • The main problem with the regulatory structure for derivatives and repos pre-2008 was that these financial instruments had special exemptions (safe harbors) from core provisions of the bankruptcy code.
  • These safe harbors were justified mainly on the grounds that they would mitigate systemic risk. The 2008 crisis showed that safe harbors worsen, rather than mitigate, systemic risk.
  • Systemic concerns cannot justify blanket exemptions from core bankruptcy provisions. Providing safe harbors only to systemically important firms would blatantly provide special financial protection to a small group of financial firms.
  • Eliminating all safe harbors for repos and derivatives would affect the market because counterparties would have to account for more risk, an outcome which should be applauded.

Part V. Protecting the Integrity of Finance

In chapter 17, “Designing an Efficient Securities-Fraud Deterrence Regime,” Amanda M. Rose explains the main flaws in the current approach to securities-fraud deterrence in the U.S., and recommends several reforms to fix these problems. Rose recommends credibly threatening individuals who would commit fraud with criminal penalties, and pursuing corporations only if their shareholders would otherwise have poor incentives to adopt internal control systems to deter fraud.

  • An optimal securities-fraud deterrence regime would minimize the social costs that securities fraud produces, and the social costs that the deterrence regime itself produces—both direct enforcement costs as well as the over-deterrence costs that result when companies fear inaccurate prosecution and legal error.
  • The best way to achieve such an optimal regime is to credibly threaten the individuals who would commit fraud with criminal penalties, enforceable by a federal public enforcer when the misconduct implicates the national capital markets.
  • Corporations should be pursued only if their shareholders would otherwise have poor incentives to adopt internal control systems to deter fraud—which is not true of most publicly traded firms—and should be threatened only with civil penalties. Fraud victims should also be granted traditional common law compensatory remedies.
  •  The current approach to securities-fraud deterrence in the United States is flawed in many respects. Most troubling is that individual fraudsters often escape liability entirely while public companies and, ultimately, their innocent shareholders are routinely punished.

In “Financial Privacy in a Free Society,” David R. Burton and Norbert J. Michel stress the importance of maintaining financial privacy—a key component of life in a free society—while policing markets for fraudulent (and other criminal) behavior. The current U.S. financial regulatory framework has expanded so much that it now threatens this basic element of freedom. For instance, individuals who engage in cash transactions of more than a small amount automatically trigger a general suspicion of criminal activity, and financial institutions of all kinds are forced into a quasi-law-enforcement role. The chapter recommends seven reforms that would better protect individuals’ privacy rights and improve law enforcement’s ability to apprehend and prosecute criminals and terrorists.

  • Financial and personal privacy is a key component of life in a free society where individuals have a private sphere free of government involvement, surveillance, and control.
  • The existing U.S. financial regulatory framework is inconsistent with these ideas and it often conflicts with basic economic freedoms. Individuals who engage in cash transactions of more than a nominal size trigger a complex set of reporting requirements that has essentially turned many companies into quasi-law-enforcement agencies.
  • Individuals should be free to lead their lives unmolested and unsurveilled by government unless there is a reasonable suspicion that they have committed a crime or are involved in illegal activity.
  • Any international information-sharing regime must include serious safeguards to protect the privacy of individuals and businesses. All efforts to improve the existing framework must focus on protecting individuals’ privacy rights while improving law enforcement’s ability to apprehend and prosecute criminals and terrorists.

In “How Congress Should Protect Consumers’ Finances,” Todd J. Zywicki and Alden F. Abbott provide an overview of consumer financial protection law, and then provide several recommendations on how to modernize the consumer financial protection system. The goal of these reforms is to fix the federal consumer financial protection framework so that it facilitates competition, consumer protection, and consumer choice. Zywicki and Abbott recommend transferring all federal consumer protection authority to the Federal Trade Commission, the agency with vast regulatory experience in consumer financial services markets.

  • The case for modernization of the consumer financial protection system is independent of the 2008 financial crisis. Fixing the federal consumer financial protection framework will facilitate competition, consumer protection, and choice for consumers.
  • Prior to the 2010 Dodd–Frank Act, the consumer financial protection regime was a mishmash system that failed to provide a coherent federal consumer financial protection regime. Authority was scattered among more than six different regulatory bodies with authority over various financial services providers.
  • Dodd–Frank consolidated some—but not all—consumer financial protection authority in the newly created Consumer Financial Protection Bureau (CFPB). The CFPB is one of the most powerful and least-accountable regulatory bodies in the history of the U.S., and it intervenes in financial market consumer-related practices in a heavy-handed arbitrary fashion that ignores sound economics.
  • Transferring all federal consumer protection authority to the Federal Trade Commission, the agency with vast regulatory experience in assessing practices affecting consumer financial services markets, would dramatically improve the federal regulatory framework for consumer financial protection.
  • Providing this type of single, clearly defined, properly limited, institutional framework for consumer financial protection will provide an incentive for financial institutions to develop innovative financial products and services that can provide consumers with more choices and lower prices.

The final chapter in this section, by Alexander Salter, Vipin Veetil, and Lawrence H. White, examines changes in shareholder liability that could better align incentives and reduce the moral hazard problems that result in excessively risky financial institutions. In “Reducing Banks’ Incentives for Risk-Taking via Extended Shareholder Liability,” the authors describe how under extended liability, an arrangement common in banking history, shareholders of failed banks have an obligation to repay the remaining debts to creditors.

  • Under today’s standard arrangement of single liability, shareholders of a failed bank have no obligation to repay the remaining debts to creditors. Under extended liability, an arrangement common in banking history, shareholders do have such an obligation.
  • Extended liability incentivizes banks to discover and undertake voluntarily the sort of practices that promote bank and system stability, and avoids the significant information and incentive burdens associated with government regulatory solutions to financial instability.
  • The incentive-aligning effects of extended liability have the potential to reduce moral hazard and thereby the social costs of excessively risky bank portfolios and the frequency of (and damage done by) large bank failures.
  • Short of eradicating moral hazard by removing all guarantees and restrictions from the banking system, the more limited change of imposing extended liability on shareholders in banks with guaranteed deposits could be a move in the right direction.

Part VI. Enabling Next Generation Finance

In chapter 21, “Improving Entrepreneurs’ Access to Capital: Vital for Economic Growth,” David R. Burton shows how existing rules and regulations hinder capital formation and entrepreneurship. The chapter explains that several groups usually support the current complex, expensive, and economically destructive system because excessive regulation helps keep their competitors at bay. Burton describes more than 25 policy reforms to reduce or eliminate state and federal regulatory barriers that hinder entrepreneur’s access to capital.

  • Capital formation and entrepreneurship improve economic growth, productivity, and real wages. Existing securities laws impede entrepreneurial capital formation.
  • To promote prosperity, Congress and the SEC need to systematically reduce or eliminate state and federal regulatory barriers hindering entrepreneur’s access to capital.
  • The regulatory environment needs to be improved for primary and secondary offerings by private and small public companies.
  • Steps should also be taken to improve small firms’ access to credit and to reduce the regulatory burden on small broker-dealers. Because many regulatory provisions are blocking entrepreneurs’ access to capital, there are a large number of policy changes that are warranted.

In “Federalism and FinTech,” Brian Knight provides an in-depth look at how financial technology or “FinTech” companies are beginning to utilize advances in communications, data processing, and cryptography to compete with traditional financial services providers. Some of the most powerful FinTech applications are removing geographic limitations on where companies can offer services and, in general, lowering barriers to entry for new firms. This newly competitive landscape is exposing weaknesses, inefficiency, and inequity in the U.S. financial regulatory structure.

  • Technology is enabling many market participants to provide services on a national basis, but because many of these providers are not banks, they are subject to state-by-state regulation.
  • This state-by-state regulation places non-bank providers at a disadvantage relative to their bank competitors because banks enjoy a much more consistent regulatory environment due to powers granted by federal law.
  • State-by-state regulation of many innovative financial services is also inefficient and gives large wealthy states an advantage over smaller states because the rich states can, de facto, regulate the national market.
  • In cases where state-by-state regulation creates significant inefficiency, harms competitive equity, or creates political inequality, Congress should consider creating a consistent national regulatory environment that displaces state-by-state regulation.
  • Conversely, in cases where state regulation does not create inefficiency, harm competitive equity, or create political inequality, such as Rule 147, Congress should refrain from imposing federal requirements.

In the final chapter of the book, “A New Federal Charter for Financial Institutions,” Gerald P. Dwyer and Norbert J. Michel propose a new banking charter under which a financial institution would be regulated more like banks were regulated before the modern era of bank bailouts and government guarantees. Under the proposed charter, which is similar to a regulatory off-ramp approach, banks that choose to fund themselves with higher equity would be faced mostly with regulations that focus on punishing and deterring fraud, and fostering the disclosure of information that is material to investment decisions. The charter explicitly includes a prohibition against receiving government funds from any source, and even excludes the financial institution from FDIC deposit insurance eligibility.

  • There have been many changes to federal banking rules and regulations during the past few decades, but there has never been a substantial reduction in the scale or scope of financial regulations in the U.S.
  • Bank regulation has increased episodically while, in the name of ensuring stability, U.S. taxpayers have absorbed more financial losses due to risks undertaken by private market participants.
  • This combination of policies has produced a massive substitution of government regulation for market competition that has, in turn, created a false sense of security, lowered private incentives to monitor risk, increased institutions’ financial risk, and protected incumbent firms from new competitors.
  • Fixing this framework requires rolling back both government regulation and taxpayer backing of financial losses. Reversing these trends will begin to restore the competitive process and strengthen financial markets.
  • This chapter focuses on one reform proposal that can implement both of these changes at once: a new federal charter for financial institutions whose owners and customers absorb all of their financial risks.

 

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