Financial stability through government regulation isn’t working.
That was the consensus of a panel held by the Cato Institute and Mercatus Center on the four year anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Heritage Foundation analyst Norbert Michel, Troy University professor Thomas Hogan, and Mercatus Center professor Lawrence White all concluded that the answer to financial stability for banks is self-regulation through the free market—not through the government.
Some conservatives claim the Dodd-Frank Act enables the “too-big-to-fail” notion rather than hampering it.
“We want to have a system in which we can allow even a large bank to fail without big spillover effects,” White said.
He argued that if certain banks are guaranteed government bailouts while others aren’t, investors will then try to “recalibrate” whether the bank they’re lending money to will be allowed to fail in a way that the bondholder takes a loss. The banks with a lower probability of being bailed out will then lose these investors, causing “havoc” similar to that of the financial crisis in 2008.
“If you keep giving banks a safety net they’re going to take more risk,” Michel said. “So stop giving them the safety net.”
A key solution to the “too-big-to-fail” issue, according to Michel and Hogan, is reforming financial institution liability. Prior to the establishment of the FDIC and the Federal Reserve, banks had double liability in case of failure, allowing depositors and equity investors to successfully regulate banks by driving down the incentive for bank managers to take undue risks, Hogan said.
“Today, we don’t really have depositors or equity investors bearing a lot of risk so they don’t need to regulate the banking system,” Hogan said.
Michel and Hogan agreed that the answer to this problem may be to revert from today’s limited liability back to a form of unlimited liability. According to Michel, this change would make it possible to provide financial firms with relief from federal regulations.
“Despite the cries that the recent financial crisis was because of deregulation, research by the Mercatus Center seems to indicate that bank regulations increased leading up to the financial crisis, and of course thereafter with Dodd-Frank,” Hogan said. “So it doesn’t seem like government regulation did a very good job of limiting systemic risk in the banking system.”