Update 177 — Hensarling’ CHOICE: A Reckless Response
Though many of us are distracted by the Comey cluster, we also know there’s likely to be a vote in the House this month that would repeal and replace almost all of the the systemic risk provisions of Dodd-Frank. Last week, the House Financial Services Committee spent three days marking-up the CHOICE Act. Committee Chair Jeb Hensarling, rather than slipping this bill through Committee under the cover of darkness, held it out in the open and heard Democrats’ objections and observed rules of order for days of detailed discussion.
This suggests Hensarling was proceeding in good faith that his legislation is well-intended. Nevertheless, the CHOICE Act upends the Dodd-Frank Act (DFA) in ways large and small. Every change in the bill is complex and it proposes to add 600 pages of financial regulation, or re-regulation, as much of it moots, contradicts, or repeals parts of hundreds of provisions. Something this massive — comprehensive would be apt but its scope and provisions are too arbitrary and ideas untested — would cost hundreds of millions of dollars and take years for institutions to comply with.
Committee Chair Hensarling may not seek to make the economy vulnerable to the market vicissitudes and unscrupulous competitive practices again. But what does he have in mind for the sector? How would his plan have fared at forestalling or ameliorating the 2008 financial crisis compared to DFA? See below.
2008’s Pre-Existing Conditions
What follows is a side-by-side comparison of what the impact would have been if in 2008, these two plans — the CHOICE Act and DFA — were enacted and their rules implemented, with industry compliance in place.
The conceit of CHOICE is that financial institutions agreeing to maintain a ten percent leverage ratio or lower will be exempt from the most significant systemic regulatory burdens, such as mandatory stress tests, establishing living wills, etc. This is a double-bind for big banks, offering them absolution from their transgressions in advance, if they’re willing to operate with their hands tied. Very few if any banks would rather operate under these terms than bear the cost of DFA regulatory compliance.
If in place, the bill and its central premise would likely have had null effect in preventing or mitigating the crisis — it fact it probably would have badly aggravated it, in fact, in view of the fact that giant firms that agreeing to Jeb’s terms would have been subject to far less regulation in 2008 as a result.
Conversely, if DFA had been in place prior to 2008, Lehman Brothers’ collapse might well have had a muted impact on the crisis — arguably, it might actually have obviated it.
Once designated as a SIFI, always designated as a SIFI, right? CHOICE provides an off-ramp for those bearing the scarlet letter. No matter — this provision would have had no impact on the 2008 crisis before or during.
The FDIC’s Orderly Liquidation Authority (OLA) would have been an invaluable tool in mitigating, if not forestalling the 2008 crash and subsequent recession. Six institutions to date have been labeled as SIFIs and their history since the designation is available for examination. These have performed extremely well financially in almost every respect since their designations.
FSOC and OLA
CHOICE 2.0 repeals DFA Title II outright , vitiating the power of the FSOC to act swiftly in response to an institutions’ impending collapse. It puts bankruptcy back on the table as a possible course of action, while eliminating the OLA outright.
But the slow-moving machinations of bankruptcy litigation (it takes years — Lehman took five) would be insufficient to handle the metastasizing of a SIFI’s failure and the overnight impact on credit markets. Given the interconnectedness of systemic firms, immediate intervention is there only hope there is of stopping an economic meltdown on the order of the recession. A bankruptcy proceeding instead of a resolution puts firms and the economy on life support indefinitely.
The DFA answer, the institution of the OLA, provides a swift end for a failing SIFIs. Putting struggling institutions out of their misery rather than bailing them out seems like a drastic, last resort solution, and it is. Where Hensarling believes DFA guarantees a bailout, the law in fact guarantees a speedy end to the failing systemically risky firm. His bankruptcy provision is hopelessly inappropriate, begs for bailouts in a crisis (if not enshrines them), whispers to Wall Street, we are preserving your competitive advantage over small banks.
Once the capital leverage ratio is implemented, CHOICE does not require compliant banks to participate in regular stress tests as before. This solves a problem which doesn’t exist — no one has demanded the end of the DFA-mandated stress tests, they are regarded as having played an indispensable role in stabilizing the financial system in 2009. There is little work required of the subject institution — the Fed does the regression analysis for you, and it’s fairly painless. And almost everyone passes them.
Credit Rating Agencies
At the heart of the 2008 crash were the credit rating agencies. The impact of the CHOICE Act on regulating them would be nil. It repeals the Franken Amendment which required a study of the possibility of a government board to manage the credit rating industry and assign ratings.
Interesting to note is that Hensarling’s argument reflects his view that the credit rating agencies are a oligopoly and lower barriers to entry would improve a sector unreformed from when they sold good grades to bad students for repeat business — tenure. It’s hard to see how Hensarling’s deregulation of the credit rating agencies before the crisis would have prevented the meltdown of 2008.
An essential piece of Dodd-Frank, the Volcker Rule restricts depository institutions or institutions which own depositories from engaging in proprietary trading. This wall between sectors of the financial industry is thought to answer some of the root causes of the 2008 crisis. Hensarling repeals Volcker entirely, calling it unnecessary. There is irony in his provisions here since Hensarling’s measure of the success or failure of DFA is, the percent of the assets of financial system (like retail deposits) are insured by the government, which does not measure risk.
The Taylor Rule, as eshrined in the CHOICE Act, would require the Fed to follow a certain formula for setting interest rates. Such a rigid structure imposed on monetary policy makers would leave constrain flexibility and denies Fed independence in an obtuse and puerile fashion. Some say it compromises the constitutionality of the Fed as an independent agency.
The CHOICE act clumsily cashiers DFA provisions that Congress approved as the best way to stop financial sector instability and taxpayer-financed bailouts. Orderly liquidation is replaced by a slow and arduous and expensive bankruptcy process when alacrity is indispensable. It does away with rules necessary for ensuring the safety of a large firm by scrapping living wills, stress tests, and classification of systemic importance of firms. All this is exchanged for a risk-blind percent leverage ratio, which Henserling mysteriously views as a panacea. His whole gambit relies on firms opting for his arbitrary leverage ratio which would inevitably limit lending, capital formation, and job creation.