The futility of banking regulation

A very enlightening article was published in the 4/16/12 issue of Barron's.  The title of the article is "The Big Flaws in Dodd-Frank" and it is written by Gene Epstein .  This article is an interview with Charles Calomiris the Henry Kaufman professor of financial institutions at Columbia Business School.

The purpose of the interview was to discuss the latest in federal regulation of the banking industry, the "Dodd–Frank Wall Street Reform and Consumer Protection Act". The interview quickly evolves into a historical discussion of banking regulation and the effects of banking regulation in the recent financial crisis. This article is an excellent source of information on these topics. I highly recommend that you spend the 10 or 15 minutes required to read it in its entirety. The article is at this link:

The Big Flaws in Dodd-Frank 

If you do not read the whole article the following are some of the highlights:

A section of Dodd-Frank was suggested by Former Federal Reserve Bank Chairman Paul Volcker.  This is some of the discussion of this new regulation:

The Volcker Rule tries to ban proprietary trading within banks. The first problem with that -- which I foresaw along with many others -- is that it would be hard to define proprietary trading, because obviously, an essential role of banks is to help make markets in various financial instruments and to execute trades for their clients.

So the question is, how do you define the limits of proprietary trading? From the hundreds of questions that they asked people and the thousands of complicated responses that they have gotten, it's become clear that there is no hope of being able to describe what it is they are trying to prohibit in a way that can be predictably identified, so that banks can know whether or not are they are in violation.

Even if it can't be done, might it still be helpful to get rid of proprietary trading by banks?

I don't think so. One thing for sure: there is no story about proprietary trading having anything at all to do with the crisis. Even Paul Volcker practically admits that.

Then what do you think was motivating Volcker?

We all have our laundry lists of what we would like to see done. Paul Volcker is somebody who has been around for a long time, and has a long laundry list. Proprietary trading by banks is just something he doesn't like, and Barack Obama wanted to hear Volcker's ideas. So basically he gets a free pass to bring his laundry list to the Dodd-Frank bill.

You don't let the crisis go to waste. 

You put it to a lot of different uses, except the ones that matter. Did the crisis have anything to do with women and minorities not being hired sufficiently by financial institutions? ..... I haven't heard anyone make this argument, so why has Dodd-Frank created new quotas for financial institutions to hire women and minorities? I don't think any of us believe that was a crisis-mitigation policy. It was just politics.

In the above passage we find that a "celebrity" in the field of financial regulation has a pet theory that he would like to impose upon society. Now that the government is trying to prevent any future crisis they decide to include this proprietary trading ban even though there is no evidence that proprietary trading made any contribution to the recent financial crisis. Even worse is the fact that no one is able to define proprietary trading, so now under Dodd-Frank no bank will know whether they are in violation of this statute.

Are you surprised to learn that this new regulation (that was passed to prevent a future financial crisis) includes employment quotas for hiring minorities and women?

Now the article moves on to the historical underpinnings for our current banking regulations:

Do you think the partial repeal of Glass-Steagall had anything to do with the crisis?

No, and the irony is that even the original of the Glass-Steagall Act, as passed in 1933, had nothing to do with the crisis it was supposed to address. Senator Carter Glass, who had been Chairman of the House Committee that drafted the Federal Reserve Act under President Woodrow Wilson in 1913, in 1933 played the same role as Volcker did some 75 years later.
On Carter Glass's laundry list was the notion that mixing investment banking with commercial banking was a bad idea. There was no evidence for that, and all subsequent research has rejected Glass's view. It's not even a close call. The Bank of United States' failure here in New York in 1930 had nothing to do with securities markets; it was exposed to Manhattan real estate and suffered losses related to the New York real-estate crash in Manhattan in 1929. Most of the other U.S. banks that failed in the 1930s did so as a result of farm problems and especially farm real-estate problems.

The Steagall part of the 1933 Act was federal deposit insurance, which was actually opposed at the time by Glass, the secretary of the treasury, the Federal Reserve, and President Franklin D. Roosevelt himself. But who did want it? Small banks in rural areas; Steagall was from Alabama. So we had ideology without evidence combined with special interests, and we got Glass-Steagall.

But what about the Glass part of Glass-Steagall? Did the ability of commercial banks to merge with investment banks have anything to do with the crisis?

Probably even less than the under-representation of women and minorities. Remember some of the illustrious names that got into deep trouble during the crisis -- Bear Stearns, Lehman Brothers, Merrill Lynch. They were all stand-alone investment banks at the time, unaffected by the partial repeal of Glass-Steagall. And we can only wish that commercial banks had done more of the relatively low-risk underwriting of securities that the repeal of Glass-Steagall permitted them to do, instead of accumulating toxic mortgages, which Glass-Steagall had not prevented them from doing.

And to make the whole argument about Glass-Steagall even more ludicrous, the repeal of the Act in 1999 made it possible for JPMorgan Chase [ticker: JPM] to acquire Bear Stearns and for Bank of America [BAC] to acquire Merrill Lynch, which helped stabilize the system.

You mention toxic mortgages. How does Dodd-Frank address that problem?

Not at all. There is no attempt in Dodd-Frank to address the key problem of government subsidization of mortgage risk, and the exposures of Fannie Mae [FNMA], Freddie Mac [FMCC], and the Federal Housing Administration are still growing.

How do you explain the omission?

There is a powerful political interest that wants real-estate lending to be sponsored by the government........Organizations like Acorn [the Association of Community Organizations for Reform Now] and other urban community activists led the fight to subsidize risky mortgage lending. Christopher Dodd and Barney Frank of Dodd-Frank, our supposed reformers, have been poster-politicians for this movement.....But Democrats were not the only ones; President George W. Bush and Speaker Newt Gingrich were also prominent proponents of subsidizing mortgage risk and facilitating the political deals that made so many risky mortgages possible.

The experience of the 1980s alone should have taught us to limit government subsidies of real-estate lending risks. There was the savings and loan crisis, which was all about speculation in real estate. There was the commercial real-estate crisis in the east after the 1986 Tax Reform Act caused some problems in commercial real-estate values.
So what did we do? In 1989 and 1991, we tinkered with capital ratios. But did we do anything to limit government subsidization of real estate risk? Quite the opposite -- the government doubled down.

Doubled down as in blackjack?

Yes, except the blackjack player doubles down by just doubling his original stake. The government effectively multiplied the bets many-fold.

How so?

The government geared up Fannie Mae and Freddie Mac -- "government sponsored enterprises" -- by allowing them to operate on very thin capital and by imposing new mortgage-lending mandates through the Department of Housing and Urban Development beginning in 1995. These mandates set growing minimum proportions of Fannie Mae and Freddie Mac mortgage lending targeting inner cities, low-income borrowers, and minority groups.

Dodd-Frank is the latest in a long history of government regulation of banking.  As  we examine these regulations a pattern appears.  The regulations are passed after a financial panic but the new regulations do not address the root cause of the recent panic.  Worse is that the regulations serve merely as a vehicle for politicians to extend favors to their supporters.  As Charles Calomiris so vividly stated " ideology without evidence combined with special interests".  Each round of government intervention has created a more fragile financial system.