Institute for Financial Transparency

Shining a light on the opaque corners of finance

18
Nov
2016
0

Minneapolis Fed makes case for repealing Dodd-Frank Act

I am sure it was inadvertent, but the Minneapolis Fed made a compelling case for repealing most of the Dodd-Frank Act.

Please recall objective 1A of the Act is to prevent having to bailout the banks again.  Objective 1B is avoiding future financial crises.

Under the leadership of Neel Kashkari, the Minneapolis Fed spent a year studying the issue of Too Big to Fail banks.  It asked the question of is this still a problem.  It asked the question of if Too Big to Fail banks still exist what more needs to be done to fix the problem.

The Minneapolis Fed concluded the problem of Too big to Fail banks still exists. In his speech introducing the plan, Mr. Kashkari observed:

When Congress moved quickly to pass the Dodd-Frank Act (the Act) in 2010, I strongly supported the need for financial reform, but I wanted to see the Act implemented before I drew firm conclusions about whether it solved TBTF.

Over the past six years, my colleagues across the Federal Reserve System have worked diligently under the reform framework Congress established and are fully utilizing the available tools under the Act to address TBTF. While significant progress has been made to strengthen the U.S. financial system, I believe the biggest banks are still TBTF and continue to pose a significant, ongoing risk to our economy.

Work under the Act wasn’t limited to just what was done by the Federal Reserve System.  It includes the work by agencies like the SEC and the CFTC.  It also includes the work by new entities like the Financial Stability Oversight Council (FSOC) and the Office of Financial Research.

The work they did included the promulgation of numerous new complex regulations.  Examples of regulations include those on bank capital, bank liquidity requirements, single counter-party exposure limitations and the Volcker Rule.  The work they did also included requiring banks to use clearinghouses when possible for derivative transactions.

Work under the Act also included stress testing these Too Big to Fail banks.

Despite all of this, the Minneapolis Fed and Mr. Kashkari concluded the problem of Too Big to Fail still exists.

To solve the problem of Too Big to Fail, Mr. Kashkari presented the Minneapolis Plan.  He provided the following table showing the benefit of the plan as a reduction in the chances of a once in a 100 year financial crisis and cost as a reduction in gross domestic product.

Table 1: Evaluating the Minneapolis Plan

Chance of bailout (next 100 years)    Overall Cost (% of GDP)

2007 Regulations                                84%                                      0%

Current Regulations                           67%                                     11%

Minneapolis Plan

Step 1                                               39%                                     24%

Step 2                                            >=9%                                <=41%

Typical cost of a banking crisis                                              158%

The row that caught my attention, Current Regulations, shows everything done under the Dodd-Frank Act only lowers our chances of avoiding bailing out the Too Big to Fail banks to slightly less than 70%.

Please consider this for a moment.  It dramatically refutes Barney Frank’s claims about the Act bearing his name that the Act achieves either objective 1A (no bailouts) and/or objective 1B (no future financial crisis).  While the Dodd-Frank Act reduced our chances of another bailout and financial crisis, even with the Act fully enforced, we are more likely than not to have another bailout and crisis in the next 100 years.

Then I looked at the cost of achieving this very limited reduction in the chances of a bailout. Mr. Kashkari described how to interpret the cost figure:

Here we calculate the present value of future costs, using a similar method as do regulators around the world….

Here we see that the Bank for International Settlements’ consensus estimate for the typical cost of a banking crisis is 158 percent of GDP, which for the U.S. economy equals roughly $28 trillion. This is the present value of the long-term effects of a banking crisis. As we have seen since the recent crisis, the U.S. economy has been growing much more slowly than had been previously expected. These long-term effects are fairly typical for financial crises, which as you can see, are extraordinarily costly for society.

Fair enough, but let the cost of 11% of GDP number sink in for a second. It is the present value of the annual reduction in GDP caused by adopting the Dodd-Frank Act.

So what is this annual reduction in GDP? According to Table 4 in Section 3.1.3 of the full plan, the annual reduction in GDP is 0.52%.

To put this annual reduction in GDP in perspective, consider over the last 150 years GDP in the US has grown on average by 2%.

The Dodd-Frank Act reduces the expected growth in US GDP over the next 100 years by 26%!

Said another way. Using the rule of 72, we would expect US GDP to double every 36 years (72/2). Roughly speaking this means in 100 years US GDP should be 8 times larger than it is today. Under the Dodd-Frank Act, we would expect US GDP to double every 49 years (72/(2-0.52)). Roughly speaking in 100 years US GDP should be 4 times larger than it is today.  This is half the size it would be without the Dodd-Frank Act.

No wonder we are experiencing such a slow recovery.

By comparison, let’s look at requiring transparency.

By definition, requiring transparency reduces the odds of bailing out a Too Big to Fail bank to 0.

Why? Investors know where they have transparency they can know what they own. They also know where they have transparency they are responsible for all losses on their exposures. This gives investors both an incentive to limit their exposure to what they can afford to lose and the ability to do so by assessing the risk of the banks.  As a result, there is no need to bail out investors in non-quaranteed bank debt or bank stock.

So what is the cost of transparency?

Effectively zero (it would be absolute zero if not for the de minimis data processing cost).

Earlier, I said the Minneapolis Fed inadvertently showed why most of the Dodd-Frank Act should be repealed.  The combination of complex regulations and regulatory enforcement barely reduces the chances of bailing out the Too Big to Fail banks or preventing another financial crises. At the same time, this combination dramatically reduces economic growth. Talk about a lose/lose proposition.

As you can see, we would be far better off requiring transparency and repealing most of the Dodd-Frank Act.