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Obamacare for the Financial Industry

The disastrous Dodd-Frank Act.

Apr 9, 2012, Vol. 17, No. 29 • By PETER J. WALLISON
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Designation as a SIFI could have profound effects on the future of the U.S. financial system. In effect, it is a statement by the government that any firm so designated is too big to fail. As we have seen before—with Fannie Mae and Freddie Mac, the largest banks, and the auto companies—if the government thinks the consequences of failure are unacceptable it will step in. The results of this policy are visible in the banking field, where the largest firms are acknowledged to be too big to fail and have been shown to have lower costs of funds than their smaller competitors. This is logical, since extending credit to a financial institution that is deemed too big to fail is bound to be safer than making the same loan to a competitor that is unlikely to receive government support. The lower cost of funds of Fannie and Freddie—a benefit derived from their government connections—enabled them to drive all competition from the sector of the housing finance market they were allowed to cover. Accordingly, if as expected the FSOC goes forward with its SIFI designations this year, the entire financial services industry will be set on a course toward domination by a few large firms that have been chosen for special government attention. 

The stakes associated with this designation are also enormous for the firms involved. A firm designated as a SIFI is then turned over to the Fed for what the act calls “stringent” regulation and supervision. The Fed’s authority is plenary, with the ability to control the firm’s leverage, liquidity, capital, and activities. This is truly unprecedented. 

All of these large firms are in competition with one another, so the Fed has the power to pick winners and losers among business models. If the Fed declares, for example, that finance companies must hold more capital, it will raise the costs of these firms in their competition with banks, and if the Fed waves its wand and decides that insurers must increase their liquidity, it will change their investment performance in comparison with mutual funds or pension funds. The Fed, in other words, has now been substituted for the market itself in allocating resources to competing industries. 

One of the dangers here is a huge increase in what has come to be called “crony capitalism.” Under Dodd-Frank an unwholesome partnership between the government and big finance is actually legislated. This is especially worrisome in light of the Fed’s extraordinary cooperation with the Treasury during the last few years. Treasury policy and Fed policy have been virtually indistinguishable since 2008, and the Dodd-Frank Act tightens this alliance by placing the Fed chair under the direction of the Treasury secretary in the FSOC. The Fed’s direct control over the day-to-day operations of the SIFIs it will supervise thus gives both the Treasury secretary and the Fed chair an opportunity to exert pressure on the largest financial firms for support of administration policy. 

In the future, it will certainly be ill-advised for the head of a SIFI to express opposition to the Fed’s monetary policies, the Treasury’s tax policies, or the president’s trade policies; a Fed finding that the firm needs more capital could be the unfortunate result. Meanwhile, a SIFI’s willingness to endorse the administration’s policies in any area might earn it the opportunity to make a favorable acquisition or to count on Fed relief if it fails to meet regulatory standards. 

Nor is the Treasury secretary’s power under the Dodd-Frank Act limited to control over SIFIs. Any financial firm is subject to seizure by the secretary if he believes that it is in danger of failure and that its failure will cause financial instability. If the firm objects, it can request a court hearing, but the hearing is secret (it’s even a crime to disclose it) and the court has a single day to make a decision. If the court does not act, the secretary can seize the firm and hand it over to the FDIC for liquidation. Needless to say, once that happens, the usefulness of further appeals is vitiated.

Does this sound like America? How can this have happened without most people knowing about it? The answer is found in Rahm Emanuel’s iconic remark, “You never want a serious crisis to go to waste.” The Dodd-Frank Act is over 800 pages in its enrolled version and was rushed through the Democratic Congress—with almost no Republican votes—in a little over a year from the time the Obama administration announced its plans. It is every bit the ideological sibling of Obamacare, and if it survives it will have as profound an effect on the future of the U.S. financial system as Obamacare will have on health care. 

Unless the Dodd-Frank Act is repealed, the era of big government —if it was ever really over—will certainly be back.

Peter J. Wallison is Arthur F. Burns fellow in financial policy studies at the American Enterprise Institute.

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