Wall St. attacked, Main St. wounded

The 2008 financial crisis was a drastic shock to the American economy. But the regulatory response in the years that followed was just as powerful a shock to the financial system.

Enshrined in the Wall Street Reform and Consumer Protection Act, known as Dodd-Frank after its main sponsors — then-Sen. Christopher Dodd, D-Conn., and then-Rep. Barney Frank, D-Mass. — the reforms were intended to protect Main Street and the public from risks imposed on them by Wall Street and financial predation. Instead, it has subjected them to risks from Washington and predatory regulators while doing little to punish the main culprits in the financial crisis.

Dodd-Frank turned out not really to be one law. Instead, it is one law for the rich and another for the poor.

It grew out of a 2009 Obama administration task force proposal, "A New Foundation: Rebuilding Financial Supervision and Regulation," and incorporated two distinct plans. One aimed at preventing bank failures from endangering the economy (the original focus of the White House task force). The other was setting up a new federal regulator, an idea first proposed in 2007 by then-Harvard professor Elizabeth Warren.

This led to the creation of the Consumer Financial Protection Bureau (CFPB). Dodd and Frank worked closely with the administration to craft the legislation and in December 2009, Frank introduced it. It contained most of the original White House proposal.

The bill was an odd marriage from the start. Warren argued for her agency as a means to protect consumer product safety. In an article in the progressive journal Democracy, "Unsafe at Any Rate," (a nod to Ralph Nader's Unsafe at Any Speed), she wrote: "It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street — and the mortgage won't even carry a disclosure of that fact to the homeowner."

Warren's comparison is superficially compelling, but it is inapt, as George Mason University law professor Todd Zywicki points out.

Loans are not toasters. The default and foreclosure crisis was caused by misaligned incentives, anti-deficiency laws and erratic monetary policy. These causes are all safety and soundness issues and not consumer protection issues.

Essentially, safety and soundness relates to banks engaging in risky or responsible lending, while consumer protection deals with fraud, deception and unfair practices in the marketplace.

The Dodd-Frank Act was sold to the American people as promoting soundness and responsibility by reining in Wall Street and the big banks. Nancy Pelosi, who was then speaker of the House, said: "No longer again will recklessness on Wall Street cause joblessness on Main Street. No longer will the risky behavior of the few threaten the financial stability of our families, our businesses and our economy as a whole."

Other items from the Left's wish list were added to the bill. Sen. Richard Durbin, D-Ill., tacked on an amendment imposing a cap on "interchange fees" charged by banks and debit card networks to merchants whose customers use the cards. The House-Senate conference added the "Volcker Rule," named after former Federal Reserve Chairman Paul Volcker, to stop banks trading financial instruments with their own money, despite the proposal not even being voted on during the bill's passage. The final law even included a provision requiring companies to disclose their use of "conflict minerals" that might have originated from the war zone in the Democratic Republic of Congo. This was supposed to stanch financial flows to warlords.

The bill passed at every stage largely along party line votes at a time when Democrats controlled both chambers of Congress. The two Republican senators from Maine also voted for the bill. Sen. Dodd suggested that the partisanship of the legislation was a good thing because compromise would be a "huge mistake" given the urgency of the problems the bill sought to address. The final act, signed in July 2010, was 848 pages long and contained more than 360,000 words. It is unlikely that many of those who voted for or against it actually read it.

Federal power grab

President Obama, left, with Sen. Chris Dodd, D-Conn., center, and Rep. Barney Frank, D-Mass., right, after signing the Dodd Frank-Wall Street Reform and Consumer Protection Act in July 2010. (AP Photo/Pablo Martinez Monsivais)
Much of Dodd-Frank is an enabling act granting power to the administration to write more legislation. "Laws classically provide people with rules [but] Dodd-Frank is not directed at people," Yale law professor Jonathan Macey told The Economist. "It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies." Those bureaucracies in turn are tasked with writing regulations.

This is a huge source of uncertainty. Dodd-Frank provides an outline, but its final rules are usually far more detailed, leaving finance firms to guess what new restrictions may come. The text of the Volcker Rule in Dodd-Frank ran to 11 pages. The agencies responsible for the rule produced a draft rule for comment of almost 300 pages, containing almost 1,500 questions for the industry. The final rule ran to 71 pages, plus over 800 pages of responses to comments and other clarifications. This process took more than two years.

By Dodd-Frank's third anniversary in 2013, the law firm Davis Polk calculated that over 15 million words of rules had been written as a result of its passage, enough to fill 28 volumes the length of War and Peace. When Dodd-Frank's required rules are complete, more than 35,000 pages will have been added to the financial industry rulebook.

To make matters worse, Davis Polk tallied up 395 new rules that the law obliged the administration to make, and each was given a deadline for finalization. At the end of 2014, only 176 of 277 deadlines had been met. Almost four years after its passage, only 58 percent of Dodd-Frank's required rules have been completed.

But that's not the end of this trail of red tape. Dodd-Frank doesn't just require rules. It also empowers agencies to create new ones as they see fit. For example, the Consumer Financial Protection Bureau's recently proposed rule to regulate prepaid debit cards is entirely a creation of the board itself. The rule is more than 800 pages on how the cards may be issued and handled. There are long and short information sheets that need to be presented to the recipient depending on circumstances, each describing a variety of fees that might be incurred. Dodd-Frank empowered the bureau to regulate such diverse financial products as auto loans, debt collection, electronic payments, mortgages, overdrafts, payday lending and overseas remittances. It is planning rules in all of these areas, too.

Dodd-Frank's impact on the financial industry is massive and burdensome. Some might respond, "Good. They deserved it!" But who really bears these burdens? It's not Wall Street but Main Street. The first two titles of the law are critical to understanding what's happened.

Title I created the Financial Stability Oversight Council (FSOC), a regulatory agency with the power to designate a firm with more than $50 billion in assets as a Systemically Important Financial Institution (SIFI) that would endanger the entire financial system if it collapsed.

Title II creates an Orderly Liquidation Authority (OLA), supposedly the means by which a systemically important institution can be wound down without a taxpayer bailout. At face value, this seems to be an improvement on the "Too Big To Fail" phenomenon that led to the crisis and bailouts, but that's not how the law has worked in practice.

SIFI status is clearly valuable, and is therefore a reward to big banks. Before the crisis, big banks benefited from investors' and depositors' confidence that the government would bail them out because of their size. Banks with more than $100 billion in assets were normally able to raise capital much more cheaply than their competitors. In practice, SIFI status has entrenched this advantage, and even extended it to more big banks because of the lower threshold of $50 billion. So smaller banks, such as Bank of New York Mellon, have been able to enjoy the advantages of easier money.

In response to this, Dodd-Frank proponents have responded that the liquidation authority shows that banks will be strained. Yet liquidation is only one of a range of options for dealing with a big institution in trouble, and is likely a last resort. Federal Deposit Insurance Corporation (FDIC) Chairman Mark Gruenberg says his preferred solution is to create a "bridge" company, with the government placing the existing company in receivership and transferring its assets to a new company set up by FDIC. This would presumably include most of the senior staff of the old company, too. Ambassador C. Boyden Gray describes the process well: "The transparency of normal bankruptcy is replaced with a black-box process that empowers regulators and favors the most influential stakeholders, including, most likely, other government-designated SIFIs."

While the costs of this operation will not come out of the Treasury Department, the rest of us will still pay for it. That's because the oversight council's power to designate an institution systemically important is not restricted to big banks. It encompasses any large financial institution. In practice, this has meant large insurance companies. AIG, GE Capital, Prudential and MetLife have been designated systemically important. MetLife is challenging its designation in court. Insurers, with the exception of AIG, which played with risky investments called credit default swaps, had nothing to do with the crisis. In fact, their business model is predicated on accurately assessing risk of payout. AIG was an outlier for having deviated from this model. They have proved exceptionally stable over the years, with lifespans far exceeding that of most banks. They are not deeply interconnected with other financial firms, and are at very low risk of presenting a systemic risk to the financial system.

Why then is the oversight council designating them as systemically important? The answer lies in the Orderly Liquidation Fund established by Dodd-Frank to pay the costs of any activities authorized under the OLA. The Fund, run by the FDIC, is capitalized by fees levied on systemically important companies. Insurance companies have large amounts of low-risk assets and therefore provide a very attractive pool of money. So in the event of an orderly liquidation, anyone with an insurance policy will be paying for the process. An April 2014 study by the consultancy Oliver Wyman found that the OLA would raise consumers' aggregate life-insurance premiums from $3 billion to $8 billion a year, with the bulk affecting retirees, who will see their incomes drop.

The regulations imposed by SIFI designation also create perverse incentives for insurers, because it signals that the FDIC will not allow the institution to fail. That could increase an insurance firms' willingness to take risks, making them less stable and making their SIFI designation a self-fulfilling prophecy.

It is, however, small and community banks — that is, Main Street banks — that are actually suffering most from Dodd-Frank. Large banks can absorb the costs of new regulations, even burdensome ones. They have large compliance departments, and can meet new challenges by simply making them bigger. Small banks only have a few compliance staffers. With millions of new words of regulation to deal with, they face a crushing new work load. "Big banks have armies of lobbyists, lawyers, consultants, and compliance staffers, without denting the banks' profitability," says Jim Purcell, chairman and CEO of State National Bank in Big Spring, Texas. "Community banks, by contrast, lack those resources, and every extra dollar of compliance costs is one less dollar to spend on customer service, one more dollar of cost that ultimately must be passed through to customers."

Small banks that face these new pressures have three options: They can increase their compliance departments and pass the costs on to their customers, they can close down (as the otherwise healthy Shelter Financial Bank of Columbia, Mo., did in 2012), or they can merge with other banks so the two can share the cost of a large big department.

Two thousand community banks and credit unions have closed or merged since 2010. A recent Harvard study found that the rate of decline in community banks as a proportion of the banking system has doubled since 2010, and that "particularly troubling is community banks' declining market share in several key lending markets, their decline in small business lending volume and the disproportionate losses being realized by particularly small community banks."

Finance not for the people

Even those Main Street banks that are surviving face problems and are reducing services. A Mercatus Center study found that many have stopped offering home loans, home equity lines of credit, overdraft protection or credit cards. Thanks to the CFPB's qualified mortgage rule, community bankers can no longer base their loan decisions on what they know about the applicant and instead must qualify applicants based on a host of consumer "protections" that have caused banks to withdraw from the market altogether. The result has been devastating for customers, who find their banking choices radically restricted. "Every dollar spent on regulatory compliance means as many as 10 fewer dollars available for creditworthy borrowers," James Hamby, president and CEO of Vision Bank in Ada, Okla., told the House Oversight Committee in 2012. "Less credit in turn means businesses can't grow and create new jobs. As a result, local economies suffer, and the national economy suffers along with them."

Other Dodd-Frank restrictions have compounded the problem. The Durbin Amendment capped "swipe fees" charged to merchants for use of debit card payment networks. Large retailers in particular had lobbied for this change for years, bridling at the profit foregone when customers use a card rather than cash or check (the Federal Reserve's check clearing system is free). While the Durbin Amendment exempted credit cards and small banks, it had a significant effect on the cost of providing debit cards to customers, since large, SIFI-designated banks, including Bank of America, JP Morgan Chase and Wells Fargo, issue a huge share of payment cards.

Merchants benefited considerably. Their fees were reduced from 44 cents to 24 cents per swipe. Retail industry groups claim the savings were passed on to consumers, but very little of the retailers' $6 billion windfall (the savings claimed by the retailers' own studies) actually made it through to consumers. David Evans of the University of Chicago Law School estimates that only about half the savings were passed back to consumers, while all the banks' foregone profits were turned into losses for customers in the form of higher fees. The net cost to the economy currently stands at $25 billion.

The effect on the average bank customer has been subtle but visible. The number of free checking accounts dropped considerably. The number of banks offering free checking halved after the passage of the Durbin Amendment. One of the few bright spots for small banks was that they were able to increase free checking because of their exemption from the cap. The average minimum monthly holding requirement for no-fee banking tripled from $250 to $750. Average monthly fees doubled.

The most pernicious effect of these fee increases is that the banking system became too expensive for about a million people, largely from the poorest sectors of society. Many people forced out of the banking system have turned to alternative financial services, such as prepaid debit cards (subject to the 800-page rule mentioned above), payday lenders and check-cashing shops.

It's not just the poor in America who have suffered from Dodd-Frank. In Africa, Dodd-Frank's conflict minerals provision has badly hurt the economy of eastern Congo, where it has "brought about a de facto embargo on the minerals mined in the region, including tin, tungsten and the tantalum that is essential for making cellphones," according to New York Times reporter David Aronson. As early as 2011, he called the law a "catastrophe" because it cut off the region's sole supply of income that could lift people above subsistence level.

The U.S. Court of Appeals for the District of Columbia Circuit struck down large parts of the provision in April 2014 as unconstitutional restrictions on speech and going beyond the remit of the Securities and Exchange Commission. Nevertheless, its effects are still being felt. The Congolese government shut most of the mines down and has begun a process for certifying minerals as "conflict-free," but as the Washington Post reported last December, its progress has been "glacial."

Constitutionally dubious

Dodd-Frank's conflict minerals provision may not be the last one to be struck down as unconstitutional. The CFPB's very design raises significant constitutional issues. The American system is based on checks and balances, with the executive branch, legislature and courts all having a say in the running of the country. Executive agencies, including independent ones, operate with the consent of Congress and the courts. The CFPB, however, is largely free from these constraints.

Congress exercises no "power of the purse" over the CFPB, because the agency's budget comes from the Federal Reserve, amounting to approximately $400 million that Congress cannot touch or regulate. The president cannot remove the CFPB Director, an executive branch official, except under limited circumstances, such as malfeasance. And judicial review of the CFPB's actions is limited, because Dodd-Frank requires the courts to give extra deference to the CFPB's legal interpretations.

The roles of the Federal Stability Oversight Council and Orderly Liquidation Authority are equally problematic. The OLA gives the Treasury Secretary the power to liquidate any financial company as long as the Federal Deposit Insurance Corporation and the Federal Reserve agree, and enables the FSOC to set bankruptcy provisions aside. This puts investors and shareholders in jeopardy based on the whim of bureaucrats.

These problems form the basis of a lawsuit challenging the constitutionality of the CFPB and FSOC brought by my organization, the Competitive Enterprise Institute, the 60 Plus Association and the State National Bank of Big Spring, and 12 state attorneys general concerned about the safety of their states' pension investments. The lawsuit was dismissed for lack of standing in 2013, but it is being appealed.

Meanwhile, the CFPB has issued a study condemning mandatory arbitration clauses that enable financial firms to extend credit to consumers that would otherwise pose too great a risk to them, and charged auto lenders with practices amounting to racial discrimination. It is also preparing a rule regulating payday lenders, all with very little evidence that any of these are causing harm worthy of regulation. For instance, the majority of studies about the effects of payday lending show no evidence that they trap borrowers in a harmful cycle of debt. The CFPB has ignored these studies and issued its own studies justifying its rule making.

Many of the rules issued because of Dodd-Frank have harmed the poorest in society, who have seen their insurance made more expensive, their banking choices reduced and their bank fees increased. Many have been forced out of the banking system altogether, only to face their other choices, such as prepaid debit cards and payday loans, more difficult to access. All experience suggests that when legal choices are restricted, people turn to illegal choices. Loan sharks and racketeers could soon make a comeback, all because of Dodd-Frank's "consumer protection" provisions.

None of this is to deny the good intentions of the bill's authors and the staff of the CFPB, but as C.S. Lewis put it in God in the Dock:

"Of all tyrannies, a tyranny sincerely exercised for the good of its victims may be the most oppressive. It would be better to live under robber barons than under omnipotent moral busybodies. The robber baron's cruelty may sometimes sleep, his cupidity may at some point be satiated; but those who torment us for our own good will torment us without end for they do so with the approval of their own conscience."

In the meantime, the bankers of Wall Street can sleep easy knowing that they can raise capital more cheaply thanks to their SIFI designation, and regulators know that a good, high-paying job awaits them in compliance departments there.