The Dodd-Frank act aimed to reform US financial markets, but is now contributing to uncertainties over growth, while posing a serious long-term challenge to competitive finance and the independence of financial institutions. At about 2,400 pages it is hardly a paragon of brevity. Even so, a surprising number of its requirements are still being hammered out by the new official regulatory bodies it created.
Agencies are racing to a July 2011 deadline to set many of the act’s regulations. Confusingly, however, some will be phased in more gradually: more than six years may elapse before the restrictions on proprietary trading are fully in place, for instance. The law also creates a worrying overlap between regulatory bodies. The Federal Reserve has overall authority, but doubts remain whether it can co-ordinate regulators with sufficient market and monetary policy expertise. The Fed’s position has also been weakened by recent criticism of its moves on quantitative easing, and by likely tougher oversight by the new Republican Congress. In short, the implementation of this act is very precarious.
Even so the greatest failing remains one of design: the act did not deal correctly with the problem of the extraordinary concentration of assets held by a small number of large financial institutions. This accelerated sharply in the 1990s with the final demise of the Glass-Steagall Act. It then took another big jump during the credit crisis. In 1990 the 10 largest US financial institutions held about 10 per cent of US financial assets. Today, the number is well over 70 per cent.
The new legislation supposedly heightens surveillance over these giant institutions, and allows regulators to engineer their orderly dissolution. This sounds plausible, but on closer examination amounts only to a new protective ring around these institutions, an arrangement posing huge risks. Indeed, dissolving a large institution will most likely increase financial concentration. For where will their assets end up, if not in the hands of the federal government, or one of the remaining giants?
A related problem is that, in a future period of monetary restraint, some large institutions not being allowed to fail will cause others to fail instead. In particular we are likely to see the disappearance of more and more regional and local institutions. Again, the assets of failing firms will end up in the hands of federal agencies or too-big-to-fail institutions. Growth in financial concentration via these paths will reduce competition enormously. Fees for all sorts of activities and financing costs will increase. One-stop shopping will become the hidden prerequisite for many demanders of credit. The large, dominant institution will, among other things, press also to be the investment banker, lender, pension portfolio fund manager, and deposit provider.
Consider, too, the implications for small business finance. Because financial conglomerates lack managers rooted in local communities, they are less well equipped than smaller, local institutions to tailor services to small business borrowers. The quality of small business finance will deteriorate and, because they continue to generate millions of jobs, the economy will suffer. Growing financial concentration will also encourage spreads to widen. In addition, too-big-to-fail institutions becoming essentially financial public utilities will undermine the efficient allocation of credit through open market trading – a centrepiece of any capitalist system.
Yet even for all these new rules, our financial system is not going be immune to the volatility that characterises market-based systems. Indeed, concentration will make it more, not less volatile, because competition will not properly restrain the excesses of the dominant players at the protected core. Moreover, portfolio shifts by a declining number of participants will induce swings in the price of financial assets where heretofore a large number of participants of smaller size tended to cushion volatility.
Simply put, the new legislation should have reduced the size of large institutions down to a level where they would not be too-big-to-fail. Even acknowledging that it takes considerable judgment to define such a threshold, any serious attempt in this direction nevertheless still would be much more desirable than enshrining the domination of big institutions in our financial system.
The concentration of monopolistic industrial companies at the turn of the 20th century gave rise to the "Progressive" movement and we have been paying for it ever since. If we don't learn from history we are doomed to repeat it. -SP