The Future of Banking: Dodd-Frank at One Year

Well, we have suffered through one year of the new financial reform act passed in 2010.

“Some critics of the law contend that it skimped on the details, leaving regulatory agencies with too heavy a burden” having to write up the specific new rules and regulations.)  

Of the 400 new rules due from the reglators, only 12 percent have been finalized while 33 percent have missed the deadline set for their finalization.  There are still 55 percent of these rules that have a future deadline.

Barney Frank, co-author of the act, said Congress had no other choice.  “We didn’t punt anything.  It’s precisely because we knew we couldn’t get everything exactly right that we did leave room for the regulators.” (http://dealbook.nytimes.com/2011/07/20/barney-frank-financial-overhauls-defender-in-chief/?ref=todayspaper)

Part of this is because Frank…and others…didn’t really know what they were doing.  The article continues “Even he (Frank) concedes that arcane financial matters were never his strong point.” Frank jokes: “I know more now about repos and derivatives than I ever wanted to know.”

The result: we have a Congressional law, the Dodd-Frank Act, aimed at preventing 2008-2009 from happening again, written by people who knew little about banking and finance but had to do something to save the world from the people who ran Wall Street. 

The major concern of Congress was about institutions that were too big to fail.  These “large” banks were to create “living wills” that provided a blueprint of the organization’s operation that would allow regulators to dismantle the bank in an orderly fashion.  (These, of course, have not been written yet.)  And, there were other things about proprietary trading and derivatives and disclosure and so forth.

My conclusion from one year of Dodd-Frank is that the financial industry will survive…in some form…and will do very well over time although not in the way Congress will like.

I must admit, my awareness of the banking and finance industry began in the 1960s.  This was really the first decade that the laws and regulations coming out of the period of the Great Depression were really tested.  The 1940s was a period the United States was focused on war; and the 1950s were devoted toward the country getting back to some kind of normality following an era of world-wide depression and world war.

In the 1960s the fifty-year period of credit inflation got its start and this changed everything.

Since this period has spanned my professional career the evolution that took place is very real to me.  The period started out very calm and contained.  Banks were very limited in what they could do and they were especially constrained geographically.  There were unit banking states where a bank could only have one office; there were limited branching states where a bank could have multiple offices although the number were limited; and there were states that allowed state wide branching.  However, banks could not cross state lines and branch in other states!

There was a definite line between different types of financial institutions.  There were, of course, the commercial banks…and the savings and loan associations…and the mutual savings banks…and the investment banks…and so on and so forth.

The products and services offered by each type of institution were severly limited and closely regulated.  Interest rate ceilings were present to protect depository institutions engaging in “destructive” competition that would weaken the banking system. 

In my mind, two major things occurred as a result of the initiation of credit inflation in the early 1960s.  First, United States corporations grew bigger and bigger.  Second, international flows of capital were freed up from earlier constraints in order to support the growth of world trade. 

The consequence of this was that financial institutions, especially commercial banks, had to break out of their constraints so that they could serve there larger customers, both within the United States and in the world. 

Financial innovation began to roll.  The four biggest financial innovations that took place in the 1960s, I believe, were the formation of bank holding companies, the creation of the negotiable CD, the allowance of bank holding companies to issue banker’s acceptances, and the invention of the Eurodollar deposit.  These innovations basically over came state laws and allowed American commercial banks to become world bankers. 

By the start of the 1970s, state banking restrictions were effectively dead and the freed-up international flow of capital doomed the gold standard which was officially buried by President Richard Nixon on August 15, 1971 when the floated the United States dollar. 

As the credit inflation continued through the last half of the century financial engineering and financial innovation dominated just about everything else other than the growth of information technology.  Perhaps the final nail in the coffin of the 1930s financial regulation was delivered in 1999 as the United States Congress repealed the Glass-Steagall Act of 1933.  This was the act that separated commercial banking from investment banking into separate organizations.

My point in reviewing this history is to make the claim, again, that “economics works.”  If there is an economic reason for an individual or institution to “get around” laws and regulations, then that individual or institution will “get around” those laws and regulations.  Some laws and regulations will fall earlier than others but these latter laws and regulations will be circumvented over time as there develops more and more reason to do so.

In other posts I have argued that the banks that were too big to fail before are now bigger and more prominent than before the recent crash.  Also, financial institutions have already moved way beyond the “intent” of the Dodd-Frank Act in the areas that have the most economic promise, have “cooled it” in other areas, and in some areas where it has not really been worthwhile for them to fight they have relinquished those minor facilities. 

Especially in this “Information Age” finance and financial arrangements are going to be harder than ever to regulate and police.  Finance is nothing more than information, nothing more than 0s and 1s (see many of my posts in the past) and information can be “sliced and diced” almost any way one wants to slice and dice it and can flow, almost instantaneously, throughout the world.

The only thing of benefit that has come out of the new financial reform act has been some increases in transparency but this has not come anywhere close to the level I would like to see happen. 

These are some of the reasons for my conclusion of one year of Dodd-Frank that the financial system will survive.  However, the system that is evolving will be a lot different than what we see now and a lot different from what the Congress and the regulators would like to see.  Also, I am still predicting that the number of financial institutions in the system will drop below 4,000 (from a little less than 8,000 now) over the next five years. 

Let’s just hope that Congress and the regulators don’t chase most of the finance offshore.