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Agenda for the 116th Congress: Banking and Finance

Perhaps one of the most under-appreciated aspects of our modern world is the fact that finance is fundamental to the operation of a free and prosperous society. It is a time machine, allowing us to move value forward and backward through time, and it acts like the oil to a smooth-running economic engine. Without it, our modern economy would grind to a halt. Indeed, as financial historian William Goetzmann has argued, in many ways it is finance that has made our current civilization possible.

A well-functioning financial system helps match investors with enterprises for mutual benefit and for the benefit of their employees and customers. On the other hand, the financial system can hinder both the efficient allocation of capital and important innovations if the government places too many restrictions on it. Where government intervention is most perverse, it can even transform otherwise beneficial financial activity into a destructive enterprise.

One of the most destructive interventions is the federal government’s housing policy. In particular, the actions of the two giant government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, directly led to the financial crisis of 2007-08. In pursuit of expanding homeownership to more and more people, the Clinton and George W. Bush administrations continually raised the subprime mortgage goals that Fannie and Freddie were required to meet until, by 2008, 56 percent of the GSE’s loan portfolio was required to be made up of low quality mortgages. This filled the financial system with toxic mortgages that were bound to fail en mass.

Fannie and Freddie’s meddling in the mortgage market was a disaster. As a result, they should be phased out and not replaced. There should be no government-sponsored enterprise for mortgages any more than there should be for other types of credit, such as car loans. This phaseout can be done through the method laid out in the Protect American Homeowners and Taxpayers (PATH) Act, which passed the House Financial Services Committee in 2013. Under the PATH Act, the GSEs sell off parts of their portfolios every year until they are completely liquidated.

Yet another problem induced by excessive government intervention is that of systemic risk and certain financial institution being considered “too big to fail.” After the financial crisis of 2007-08, Congress passed the largest piece of legislation ever written, the Dodd-Frank Act, to try and end too-big-to-fail. Yet many of its provisions enshrine too-big-to-fail and the expectation of bailouts for such large financial institutions. In fact, it doubled down on the bank regulatory regime that failed to prevent the financial crisis. The big banks are more dominant now than they were before the crisis. The vastly increased regulatory burden imposed on smaller banks has led many of them to merge to become bigger, in order to be able to withstand the increased regulatory costs. Such overregulation has also made banks wary of lending to people without perfect credit or to small businesses and startups.

A better alternative to Dodd-Frank would be the Financial CHOICE Act, most famously championed by former-House Financial Services Chairman Jeb Hensarling (R-TX). The CHOICE Act, among other things, creates a regulatory off-ramp for banks that hold enough capital to buffer a down market. This is a common sense measure that allows banks to choose between higher capital standards or higher regulation and to tailor their business models accordingly.

Even further, to really end too-big-to-fail, Congress must minimize the damage to the financial system from any one bank’s failing by limiting deposit insurance and allowing more competition. Deposit insurance creates moral hazard because banks know they will be bailed out if they take too many risks. Meanwhile, depositors lack incentives to monitor how much risk their banks are exposed to. The private sector can create more responsive mechanisms of insurance.

Innovative new entrants should also be allowed to compete in the financial services industry. Since passage of Dodd-Frank in 2010, federal regulators have allowed only a dozen new banks to open for business. Well-managed nonfinancial firms, such as Walmart and Berkshire Hathaway, have been rebuffed in their attempts to open affiliated banks to serve consumers. Virtually no other developed country has such restrictions to entry. For example, the retail giant Tesco runs one of the largest banks in the United Kingdom. Keeping banking as an “old boys’ club” with few new entrants makes the financial system less competitive and less safe.

Another area in desperate need of reform is the Consumer Financial Protection Bureau, perhaps the most powerful and unaccountable regulator in the entire federal government. Congress exercises no power of the purse over the Bureau because the agency’s budget comes from the Federal Reserve. That amounts to approximately $600 million that Congress cannot touch. Further, the president cannot carry out his constitutional obligation to “take care that the laws be faithfully executed” because he cannot remove the Bureau’s director except under limited circumstances.

While the reforms above would largely reshape the financial system as we know it, there are plenty of smaller, but still pressing, issues to deal with. One such example of bipartisan interest is fixing the mess that was created by a Second Circuit Court of Appeals case, Madden v. Midland Funding, which has severely impacted the development of financial technology in certain regions of the country. Madden overturned the centuries-old “valid when made” doctrine in the Second Circuit—under which loans that were considered valid in the state they were made could not be considered usurious when sold to an out-of-state party. The ruling created massive uncertainty in the lending market that could devastate fintech innovations such as peer-to-peer lending. In 2015, when the case was decided, the number of loans made to less creditworthy borrowers in the Second Circuit declined by 52 percent from the previous year, whereas it increased by 124 percent outside the Second Circuit during the same time period. Congressional legislation codifying “valid when made” as law could boost borrowers’ and investors’ opportunities everywhere.

When functioning properly, the financial system can be a tremendous force for prosperity and progress, providing consumers with the credit they need to finance their lives; entrepreneurs with the capital they need to turn their ideas into reality; and investors with wealth-building opportunities. In order to ensure that the financial system is operating smoothly, Congress should adopt these recommendations laid out in CEI’s agenda for Congress.

For more, read CEI’s “Free to Prosper: A Pro-Growth Agenda for the 116th Congress.” Previous posts in the Agenda for Congress series: