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Ditching Dodd-Frank: How to Really Fix the Banking System

John Engle
Dodd-Frank

In the aftermath of the financial crisis of 2008, Democratic lawmakers went hog-wild writing a thicket of new banking regulations. The American public, scared and feeling betrayed by what was perceived as the greed of Wall Street, was more than happy to see new regulations and punitive rules enacted. However, in creating a new regulatory regime of unprecedented complexity, opacity, and reach, these lawmakers gave birth to a monster.

The Dodd-Frank law, the centerpiece of the new regulatory framework, attempts through its vast array of rules to prevent another financial crisis by foisting controls over both financial institutions that are deemed systemically important, and the industry as a whole. The result has been more and more red tape for the financial services industry to struggle through. In the process, smaller banks have been crushed by the gargantuan national banks that Dodd-Frank ostensibly distrusts.

Small banks have to play by the same rules, but the rule book is so big and complicated few banks can afford the compliance costs; larger banks that can afford expansive compliance departments have been able to survive and thrive while smaller institutions sputter and fail.

And Dodd-Frank probably won’t even succeed at its main purpose of stopping systemic financial crises. It will fail because it assumes that the catalysts of future shocks will be the same as they were in 2008. Bubbles can emerge in various sectors (usually thanks to government interventions), and are rarely understood by regulators or the public before they burst.

It’s not hard to convince a libertarian that Dodd-Frank is terrible. But simply jettisoning it will never be accepted by the American voting public. Yes, many of them have come to understand that Dodd-Frank is terribly flawed, but the vast majority still support some form of regulatory mechanism, one with provisions for dealing with crises. That attitude is not likely to change any time soon, if ever. Mistrust of Wall Street and big financial institutions around the world runs deep. So the question we should be asking is not whether we should have any banking regulation, but rather what would be a superior replacement that both libertarians and a not-so-libertarian American public can get behind.

There is a solution that could work, one that could win the support of both the Tea Party folks and the Sandinistas. This solution is controlled nationalization in the event of bank failures.

Yes, yes, I know. A libertarian proposing nationalization of businesses sounds like madness, but hear me out.

 

Libertarian Nationalization

Any regulatory regime has to decide how to do two things: Monitor the day-to-day practices of institutions, and respond to crisis.

A libertarian solution to business problems should naturally seek to limit the involvement of government in the day-to-day running and monitoring of businesses. What I propose is that government essentially vacate this role, get out of the way of the finance industry, and let it get on with business unencumbered by heavy-handed regulations. Basically, return the rules of banking to pre-Dodd-Frank levels, and hopefully even looser.

So far, so libertarian.

The problem with taking this action alone should be obvious: the voters and our political masters will never go for it. There will always be overpowering pressure for government to intervene when things go wrong, especially in the event of systemic crises. No government will be allowed to sit on its hands when banks go under one after another. The expectation is, and will continue to be, that government will step in to save the financial sector and protect consumers.

So there needs to be some mechanism wherein government can do something without creating even more problems. This is where nationalization comes in.

The policy can, and should, be simple and clear: If a bank goes under or needs a bailout to keep operating, the government doesn’t hand out cash to prop it up. Instead, it nationalizes the bank, fires the bank’s C-suite and directors (and bans them from serving in the financial services industry for a couple decades for good measure), and recapitalizes the bank to restore it to solvency. If it is a large bank, the nationalized entity could also be broken up and sold off either as assets to other banks or as smaller, independent institutions.

The basic result of such a policy is this: a laissez-faire attitude toward banking and finance to allow for maximum innovation and competition, combined with the threat of firing and proscription to keep managers in line, all while providing a public aegis to ordinary consumers and the financial system as a whole.

 

A Fairer, Better Way

This new system would be far fairer than any that has existed in the age of modern banking. Before the financial crisis, and still today, the biggest financial institutions have enjoyed the tacit backing of the government. They know they are too big too fail, so they can act in ways that would lead to their eventual demise if they operated in a true free market. The risk-taking behavior in the run-up to 2008 was largely the product of bankers making the rational calculus that they could make huge amounts so long as things went well and that they would be saved by the Feds in the unlikely event that things went badly.

Ordinarily, the risk of going under and losing everything moderates the behavior of managers. Because that does not, and will not likely ever, happen in the financial system, an alternative is required. Nationalization of failing banks and proscription of their leaders is a way to create the huge personal costs to decision-makers without also exposing the depositors and the financial sector as a whole to the consequences of system-wide bank failures.

The system also has the benefit of clarity. Currently, banks may or may not be saved by the government. So while the biggest ones may be sure of rescue, there are some operating in a gray space. When one of these banks goes under thanks to recklessness, it may cause panic across the financial system, resulting in a cascade of failures. This can pull down even financially sound banks, which can damage the entire economy. An iron-clad promise (and threat) of nationalization for banks of any size would create the certainty on which complex financial systems rely.

It is also fairer because it does not play favorites and does not benefit those banks with deep political connections. It is no secret that Wall Street, the Federal Reserve, and the federal government have deep ties to one another, with senior people moving between them quite frequently. There is nothing inherently wrong with that; in fact, it should be considered a good thing that capable and knowledgeable people are able to move around to posts that suit their talents. But that benefit must be balanced with the knowledge that human beings are imperfect and prone to favoring their friends and allies. This is especially true for those in the political sphere. By not favoring anyone, the system I propose would eliminate both the perception and the reality of favoritism in the highest echelons of finance and government.

It will likewise level the playing field somewhat for smaller banks. During the financial crisis, many small banks were obliterated by the financial tsunami touched off by the roiling of the big banks. And while the titans of Wall Street could grasp the lifelines provided by government bailouts, innumerable small fries were drowned in the deluge. In the aftermath the big banks were further advantaged by the vast regulations that made compliance a headache for them but ruinously expensive for their smaller competitors.

 

Practical Steps Toward Freedom

The beauty of my proposal is that it has something for everyone. For the right wing it clear-cuts a huge array of regulations and rules and allows the financial system to innovate and thrive once more. For the left it provides clear and serious consequences for bank failure, protects consumers and the financial system from failure and contagion, and punishes bankers who overstep due to greed. This proposal can be sold to all sides of the political spectrum. The only people who won’t like it very much are the regulators themselves and the bankers who have been enjoying their cozy government backstops.

Free market purists will always say that we should just get government out of the way and not compromise. But in a world of many stakeholders and competing ideologies, sometimes we need to consider novel paths to achieving comparatively more economic freedom.

Our mission should always be to make the world we live in more free than it was before. This policy does that. It may demand an occasional heavy hand from the government, but it serves the core tenet of moving civilization closer to the ideal of freedom that we as libertarians cherish.

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John Engle

John Engle is a merchant banker and author living in the Chicago area. His company, Almington Capital, invests in both early-stage venture capital and in public equities. His writing has been featured in a number of academic journals, as well as the blogs of the Heartland Institute, Grassroot Institute, and Tenth Amendment Center. A graduate of Trinity College Dublin, Ireland and the University of Oxford, John’s first book, Trinity Student Pranks: A History of Mischief and Mayhem, was published in September 2013.
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