October 17th, 2017


Preventing the next Wall Street panic

Robert J. Samuelson

By Robert J. Samuelson

Published August 1, 2016

WASHINGTON -- The hostility toward Wall Street remains so great that both political parties say, in their platforms, that they'd like to break up America's biggest banks. But before engaging in this drastic economic surgery, it's worth examining whether Dodd-Frank is working. Recall that the law, named after its congressional sponsors, former Sen. Senator Christopher Dodd and former Rep. Barney Frank, overhauled the financial system to make it more panic proof. Is it? The answer may surprise.

The Obama administration's position is clear: "We can say without question that Wall Street reform has made our financial system safer and sounder," Treasury Secretary Jacob Lew recently said on the sixth anniversary of the law's signing. Up to a point, this is true. Banks are required to have more capital than before the 2008-09 financial crisis, and this crea

tes a larger buffer against losses. Capital typically -- but not always -- consists of shareholders' investments in banks. In 2016, the ratio of the biggest bank-holding companies' common stock to risk-weighted assets (loans, securities) was 12.2 percent, more than double its level in early 2009, says the Federal Reserve.

This means that banks can better survive severe economic shocks -- deep recessions or speculative excesses. Since 2009, the Fed regularly subjects major banks to a computer-driven "stress test." It simulates a deep slump and examines how banks would fare. In the latest stress test, unemployment was assumed to double to 10 percent, the stock market to lose half its value, and the economy's output to drop nearly 8 percent, larger than the decline in the Great Recession.

Under these conditions, estimated bank losses were huge: $385 billion, says the Fed. Borrowers defaulted; bonds lost value. Still, sufficient capital remained that all 33 bank holding companies -- those with assets exceeding $50 billion, representing about four-fifths of the banking sector -- continued to meet regulatory capital requirements. The capital ratio dropped from 12.2 percent to 8.4 percent. But that was well above the 4.5 percent required minimum (for large banks, the minimum can be higher).

This is good news. The essence of the 2008-09 financial crisis was a panic among large depositors (hedge funds, pension funds, corporations) -- a bank "run." They withdrew their money from banks, because they didn't know whether the banks were solvent. If banks' capital cushions had been larger, these fears might have been allayed and the withdrawals limited. In reality, the outflows threatened a second Great Depression, as banks cut lending and dumped bonds to meet depositor demands.

What avoided another Depression was the quick response of the Federal Reserve, which -- acting in its role as "lender of last resort" -- supplied trillions of dollars of credit to banks and other financial institutions to offset the loss of private credit. Without these infusions, who knows what would have happened.

Now, the bad news. In Dodd-Frank, Congress makes it much harder for the Fed to act as lender of last resort, says Hal Scott, a professor at Harvard Law School and a respected expert on financial regulation, in his book "Connectedness and Contagion: Protecting the Financial System from Panics." The consequences, argues Scott, could be catastrophic. A U.S. depression would "pose challenges to our political system," as well as spreading abroad and undermining the U.S. global role.

During the financial crisis, the Fed relied on section 13(3) of the Federal Reserve Act. This provision gave the Fed wide discretion in making loans when "unusual and exigent" circumstances prevailed. Now, Dodd-Frank has imposed restrictions on 13(3). As Scott shows, these include: The secretary of the treasury must approve all nonbank loans; there can be no nonbank programs for a single borrower; collateral requirements are toughened; loans must be disclosed within a year. Some of these may be sensible alone; together, they create an obstacle course for crisis lending.

Scott estimates that $7 trillion in funds are potentially vulnerable to panicky investor runs. Breaking up the big banks is no solution if, say, the investor run strikes money-market mutual funds.

There is a real issue here. The Fed has enormous powers; democratically elected officials think they should exercise some control over those powers. But a financial crisis -- a panic -- is by its very nature a rapidly moving event that usually was unpredicted. (If anticipated, it could likely be defused.) Unless the crisis is dealt with decisively, it could become a monster that cannot be contained.

The verdict on Dodd-Frank is mixed. One goal was to improve short-term financial stability. That has been achieved. The other goal was political: to handcuff those who engineered the financial "bailout," which -- though necessary -- is immensely unpopular. That explains why Congress restricted the Fed. Ironically, legislation designed to protect us from financial panic may make some future panic more likely.     

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