November 12, 2014 | Commentary on Economy, Bailouts, Financial Regulation, Recession and Recovery

Repeal Dodd-Frank and End Too Big To Fail

The Republicans will hold a comfortable majority in the U.S. House and, at most, a 55 seat majority in the Senate for the 114th Congress. That’s not a wide enough margin to override a Presidential veto. Still, the Republicans owe it to their constituents to exercise governance.

On election night Sen. Mitch McConnell (R-KY) indicated Republicans will, in fact, try to do just that. The next Senate majority leader told his supporters: “This experiment in big government has lasted long enough. It’s time to go in a new direction.”

Financial market reforms are the perfect litmus test for whether McConnell really meant what he said. There are literally thousands of pages of new regulations that should be eliminated, and that’s only part of the problem.

During the 2008 financial crisis, a bogus narrative arose purporting to explain what had gone wrong. The demonstrably false notion that deregulation caused the crisis persists even today.

It’s easy to show that financial markets were not deregulated leading up to the crisis, but conservatives shied away from this fact. They even missed the opportunity to show the opposite is true: that financial regulations, steadily increasing for decades, contributed to financial turmoil.

But now conservatives have the opportunity to atone for this mistake, regardless of what they can get through the new Senate. They can start by defending the truth: Financial regulators never took a vacation during the Reagan and George W. Bush years.

Had financial regulations been slashed during these years, the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act could have simply restored those that had been eliminated. Dodd-Frank didn’t do so because there were none to restore.

Furthermore, the lists of so-called deregulatory policies typically offered as evidence of crisis-inducing financial market deregulation are nothing of the sort. Instead, they simply demonstrate that Congress made many changes to pre-existing regulations. That’s not deregulation.

Still, the deregulation story won the day, and the regulatory state was expanded. Now, on the heels of their election triumph, conservatives are in a much better position to stick to their principles.

And if they really do stand for limited government, the perfect place to start is by shutting down Fannie Mae and Freddie Mac, the two government-sponsored housing firms that played a central role in the 2008 crisis.

In the last Congress, House Republicans offered two different bills which would have accomplished this task. The Senate, though, offered a so-called bipartisan compromise.

That approach would have shut down Fannie and Freddie, but it also would have replaced them with companies explicitly guaranteed by taxpayers. Somehow, this was supposed to be an improvement over the old system, where Fannie and Freddie enjoyed implicit taxpayer backing.

To this day, the two companies remain under government control and virtually untouched by any of the added regulations or capital requirements Dodd-Frank forced on private firms.

If conservatives really want to fix our financial markets and ensure that taxpayers won’t have to bail out troubled financial firms – or their creditors – again, they’ll seize the opportunity to implement real reforms. The following list is a good start.

  • Repeal Dodd–Frank. The 2010 Dodd–Frank Act’s answer to the financial crisis was to institute more federal regulation and oversight, despite the fact that this approach has failed repeatedly in the past. Many components of the act did virtually nothing to address the root causes of the financial crisis and simply expanded implicit taxpayer backing for financial firms. Overall, the act has succeeded only in further socializing the cost of financial risk-taking, thereby increasing the likelihood of future financial crises and bailouts.

  • Amend bankruptcy laws to establish an orderly resolution process for large institutions. There is clearly a need to fix this process. Short of repealing Dodd–Frank in its entirety, the next best solution is to eliminate Title II of the law. Amending the bankruptcy laws so that a credible resolution process exists for large financial firms is a key component to ending the too-big-to-fail problem.

  • End the Fed’s broken lender-of-last-resort function. There is no clear economic rationale for the Fed to provide direct loans to private firms. Given the development and current sophistication of financial markets, there is now even less reason to let the central bank serve as a lender of last resort than there was in 1913. Congress should help to minimize the chances of future too-big-to-fail-style bailouts by revoking the Federal Reserve’s emergency lending authority and closing the discount window.

  • Permanently shut down Fannie and Freddie. Government-sponsored corporations Fannie Mae and Freddie Mac should be eliminated altogether. The housing market will ultimately be stronger by relying on private financial firms that are not backstopped by taxpayers. Allowing the companies to restart or replacing them with explicitly government-guaranteed firms all but ensures future housing market turmoil. The U.S. homeownership rate is barely any different today than it was prior to the creation of Fannie and Freddie. These institutions simply are not necessary for widespread homeownership.

  • Eliminate the Financial Stability Oversight Council (FSOC). Among other things, the FSOC designates certain companies as systemically important financial institutions (SIFIs). Those companies then receive heightened supervision under the Fed. In practice, this means the FSOC regulators are designating which firms they consider to be “too big to fail.” In the near term, Congress should force the FSOC to be more transparent about how it arrives at these decisions, and it should lift Dodd–Frank’s restrictions on legal challenges to the FSOC’s designations. However, Congress should still recognize that the mere existence of the FSOC is wholly incompatible with the functioning of a dynamic private capital market. Separately from a repeal of Dodd–Frank, Congress should eliminate the FSOC.

The notion that there has been any sort of substantive deregulation of financial markets in the last century is completely wrong. The reality is that the near continuous expansion of the federal regulatory framework solidified the belief that large, financially troubled firms would be supported with taxpayer money.

Rather than ending “too big to fail,” the Dodd–Frank Act has enshrined it into law. Congress can reverse this misstep by repealing the Dodd-Frank Act and implementing the reforms outlined above.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Forbes