Why Dodd-Frank Is a Protection Racket for Banks

By Edward Kane, Professor of Finance at Boston College. Originally published at the Institute for New Economic Thinking website

Ten years after the crisis, financial regulation leaves taxpayers holding the bag for banks’ safety net.

Regulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time. In this game, regulatees tend to make more moves in pursuit of safety-net subsidies than regulators can or do make to stop them. Moreover, regulatee moves tend to be faster and more creative, and to have less-transparent consequences than the moves that regulators make.

In modern times, banking crises have occurred when managers pursued concentrated risks that made their institutions increasingly vulnerable, but generated a series of substantial and long-lasting safety-net subsidies until things finally went south. As I explore in my new INET working paper, such subsidies can prove long-lasting because the regulatory cultures of almost every country in the world today embrace—in one form or another—three strategic elements:

  1. Politically-Directed Subsidies to Selected Borrowers: The policy framework either explicitly requires—or implicitly rewards—institutions for making credit available to favored classes of borrowers at a subsidized interest rate. In recent crises, subsidized loans to homeowners played this role. However, the next crisis may feature loans to current and former students, pension funds, and state and local entities;
  2. Subsidies to Bank Risk-Taking: The policy framework commits government officials to offer on subsidized terms explicit and/or implicit (i.e., conjectural) guarantees of repayment to banks’ depositors and other kinds of counterparties engaging in complex forms of bank deal making;
  3. Defective Monitoring and Control of the Subsidies: The contracting and accounting frameworks used by banks and government officials leave no paper trail. They are careful not to make anyone directly accountable for reporting or controlling the size of these subsidies in a conscientious or timely fashion.

Taken together, the first two elements of the subsidization strategy invite commercial and investment banks to use the safety net to extract wealth surreptitiously from ordinary taxpayers. To keep subsidy-generating leverage high, the bulk of the subsidies banks receive are promptly paid out to top managers and to shareholders in the form of dividends and share repurchases. The rest is shifted forward and backward: mostly to large creditors and politically favored borrowers, but a few dollars might be reserved for like-minded academic researchers and community groups.

Favored borrowers are primarily blocs of voters (such as would-be homeowners) regularly courted by candidates for political office and traditional sources of outsized campaign support (such as bankers, landlords, builders, and realtors). Ferguson, Jorgensen, and Chen (2017) define a comprehensive concept of the “spectrum of political money” that captures a number of indirect and subtle ways that bankers (especially) put money into a politician’s pocket or election campaign. The direct ways include director’s and speaking fees, book contracts, jobs for family members, and stock tips, plus of course campaign contributions. Indirect channels comprise threatening to support an opponents’ campaign or laundering donations through law firms, charitable foundations, think tanks, community groups, and public-relations firms.

The third piece of the framework minimizes regulators’ exposure to blame when things go wrong. Gaps in the reporting system make it all but impossible for outsiders—particularly the press—to hold supervisors culpable for violating their ethical duties. These gaps prevent outsiders from understanding—let alone monitoring—the true costs and risks generated by the first two strategies. Few politicians and regulators want to subject the intersectoral flow of net regulatory benefits to informed and timely debate.

This weakness in accountability exists because the press is often content with regurgitating the content of agency press releases and because accounting systems do not report the value of regulatory benefits as a separate item for banks and other parties that receive them. In modern accounting systems, the capitalized value of regulatory subsidies is treated instead as an intangible source of value that, if booked at all (as it usually is in acquisitions), is not differentiated from other elements of what is called an acquired bank’s “franchise value.”

Of course, some of the subsidy is offset by tangible losses that politically influenced loans eventually force onto bank balance sheets and income statements. Although officials resist the idea, creating an enforceable obligation for regulators to estimate the ebb and flow of the dual subsidies in transparent and reproducible ways would be a useful first step in getting them under control. This would make it easier for watchdog organizations in the private sector to force authorities to explain whether and how these subsidies benefit taxpayers.

But Hasn’t the Dodd-Frank Act Changed All This?

The Dodd-Frank Act (DFA) is best understood as a collection of policy measures designed to weave its way respectfully through different industry lobbyists’ self-absolving alternative theories of the crisis to incorporate a (sometimes lame) treatment of the forces featured in each of them. What I find ironic in this massive and allegedly comprehensive legislation is that the particular problems that the banks’ testimony stressed all point to the interaction of the pair of implicit subsidies that my narrative highlights.

These subsidies are hidden in the systems used: (1) to finance housing investments on the one hand, and (2) to finance payouts from the US financial safety net on the other. In turn, the norms that make these subsidies durable are rooted in a generalized breakdown in professional ethics that the DFA does not treat at all. The professions of government service, accounting, financial management, credit rating, mortgage banking, derivatives broker-dealer making, and government regulation all have explicit or implicit codes of practice that (wink, wink) members of the profession are expected to follow to prevent client, user, or societal abuse and to preserve the integrity of that profession. In some countries and professions (especially medicine), violations of particular standards that impose predictable harm on other parties become a matter for law enforcement. So (I believe) it should be in finance.

Focusing Only on Bank Capital is a Loser’s Game

It is fiendishly difficult for incentive-conflicted leaders of regulatory agencies to control firms that capital markets perceive to be macroeconomically, politically, or administratively too difficult to close and unwind. For such megabanks, the Basel approach of setting capital requirements only against what have become well-understood and easily measurable exposures is massively inadequate. To mimic the methods by which private counterparties keep the other side’s opportunities for weaseling out of losses under control, capital requirements have begun to introduce small capital surcharges designed to increase both with an institution’s size and with the opacity of its deal making. But further reform legislation passed in 2018 benefits giant banks in two ways: by doing nothing new to rein in their ability to command safety-net subsidies when they are in distress and by expanding access to these subsidies for their custody activities. As always, an unreformed and elitist justice system continues to grant megabankers near-impunity for forcing the safety net—rather than their stockholders—to finance their firms’ deepest risk exposures.

Managers of temporarily well-capitalized banks are pressuring regulators to let them use dividends and stock repurchases to distribute as much of their current earnings as they can. Worse yet, regulators add their blessing to bankers’ bullsh*t claim that this is okay because low current levels of safety-net subsidies mean that safety-net subsidies are safely under control. While it is true that the value of safety-net guarantees is relatively low at U.S. megabanks today, this is because safety-net subsidies recede as a bank begins to build up its capital even a little. But the dialectical process I have outlined explains that, contrary to Adamanti and Hellwig (2013), increased capital requirements and incentive-conflicted stress tests cannot keep taxpayers’ loss exposure in megabanks under control for long. Whatever the level of capital requirements, the taxpayers’ stake increases when and as (notice I do not say if) bankers find new and better ways to hide leverage, tail risk and distress from their supervisors.

In principle, stress tests can compensate for some of the weaknesses in the design and implementation of capital requirements But in practice, stress tests focus narrowly on only a few very-specific scenarios. Because neither capital requirements nor stress tests measure taxpayer risks appropriately, stress tests merely add an overlay of bullsh*t to the perseverance of the citizenry’s hard-to-shake belief in the supervisory process. In any case, it looks as if regulators have stopped using these tests to assess the volatility of taxpayers’ stake in large banks. Beginning this year, the Fed appears to have repurposed the tests as a way to provide supervisory cover for captured regulators to permit the megabanks to use share buybacks and dividends to pay out enough of their accumulated profits to drive their safety-net subsidies up again.

Most commentators argue that U.S. megabanks are safer now that they were in 2007- 2008. But that is a superficial test. A more-important and unasked question is: For how long? Figure 1 tells us that the process of rebuilding megabanks’ leverage-driven tail risk by means of dividends and stock buybacks is already getting underway. Equally worrisome, bank information systems do not even try to track taxpayers’ stake in banking firms and the regulatory, supervisory and justice systems remain focused on disciplining banks, rather than bankers.


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    1. Ginavon

      your financial holdings, while in possession of said bank, actually have been loaned to the bank. This means that in the next crash…the bank puts your accounts on a list of creditors they owe and there are 7 types. You the individual are on the bottom of the “payback list” and you will lose all your money. The FDIC insurance is void and null because they do not have enough money to insure that many people. So OOPS! You lose again! Isn’t this fun? Our lawmakers do not even read legislation before they pass it. Go figure. If you, as a citizen read the legislation, as I do, you will find yourself losing your mind when you see how the wealth of the masses …what is left of it…is being plundered at every turn.

      1. Ginavon

        You will really start to feel crazy when you watch mainstream media….and how the DEMOCRATS have lost their minds to hyper emotional states of thought and activity precluding any semblance of logical thinking. It’s like watching a really bad zombie movie without the makeup!

      1. Ginavon

        Exactly…allow the pain…alow the reset to happen. The pain will be worse now because they kicked the can To the next administration.

    1. Adam Eran

      Re-pass Glass-Steagall, for one. Then staffing the various regulators (OCC, OTS, the Fed, etc.) with regulators who would actually enforce the law, even laws like Sarbanes-Oxley that would have held the C-suite guys responsible for the frauds their institutions perpetrated… That would be a nice start.

      1. D. Chekouras

        Second, bring back chapter 11 bancruptcy for citizens, taken by the Credit Act of 2006. “People are corporations too!”

    2. worldblee

      That question ignores the fundamental nature of the Democrats being water carriers for the FIRE (Finance, Insurance, Real Estate) sector. Their job is to protect Wall Street and the big banks, not do anything to regulate them, let alone make their lives more difficult.

      And no, this is not to exculpate the Republicans either, as both parties are entirely corrupt.

      1. Ginavon

        MAXINE WATERS IS CURRENTLY UNDER INVESTIGATION for financial fiasco……all other Democrats are financial rats too. They are all on the take. Some senators also…TREY GOWDY NET WORTH? Apron 190 thousand dollars. One honest man among hundreds of thieves. Tray Gowdy for ATTORNEY GENERAL…..!

    3. johnnygl

      1) avoid dumping losses on taxpayers. Wipe out equity and bondholders first. Most commentary i’ve seen suggests that would have covered the losses, without having to dig into depositors.
      2) a large audit would have revealed that the assets on the books of the big banks were not worth nearly as much as advertised and justified the action taken in item 1) and necessitated taking them into receivership (like was done with the GSEs).
      3) a comprehensive audit would have reveal pervasive fraud at every stage of the mortgage lending and securitization process. This would have created pressure for lots of prosecutions of top officers and directors. The bankruptcy trustee for LEH pointed to lots of areas that were indicative of fraud. These were never investigated. Because of this, the ridiculous idea that ‘if lehman had been bailed out, everything would have been fine’ has become an acceptable argument in the crisi retrospectives. It shouldn’t be given any credence.
      4) there was no serious attempt to stabilize households and communities. Lots of mortgage mods needed to be done to keep homeowners in their homes and prevent the collateral damage to society of having vacant, deteriorating homes becoming pervasive around many neighborhoods. This sort of thing wasn’t done because it would have forced to authorities to reckon with the issues discussed in items 1) and 2)

      These items were all entangled and obama’s crew did none of them. Instead the whole financial system was preserved as is, including the capital structure of the institutions involved. They cordoned it off and put the fed funds rate at zero for around 7 years while the banks dug themselves out of the hole they made.

      1. Ginavon

        Obama did not understand it so he did what he was told to do. I hate Obama and I hate myself for voting for him as it was the worst mistake many of us ever made. Don’t make the same mistake in the midterms 30 x CIA employees are on the Democrat ticket in 2018 midterms. Investigate your candidates for all positions before voting! NEVER AGAIN #WALKAWAY

  1. Jeremy Grimm

    After the Great Recession in 2007-2008 the American public was not very happy with the government’s handling of the problem. I’m unhappy about how the government is working to prevent a second Great Recession. Somehow this country managed to get from the Great Depression to sometime in the 1970s without the excitement and fireworks the FIRE sector brought us after that — climaxing in the Great Recession. I think a great many people will be very very unhappy when the second Great Recession occurs. The FIRE sector is playing with fire.

    1. Ginavon

      Recession coming? Try total crash of fiat money system…and/ or hyper inflation of the dollar. Reset of world economy is coming….are you prepped for it? Even if I am wrong are you willing to Rick watch your children stand in line for soup or rifle through garbage on the street for food…think it cannot happen? Look at Venezuela, Greece, one by one you will see other countries fall. President Trump announced in Sept of 2018 that September is national preparedness month. In October 2018 President Trump ran a test of the emergency system…perhaps the president, who has the highest security clearances in the world knows something we don’t?

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