As opposition mounts to post-crisis regulatory reforms, scholars should rethink their critical evaluation of the progress that has been made
After his inauguration on 20 January 2017, U.S. President Donald Trump announced his intention to roll back key sections of the Dodd-Frank Consumer Protection Act signed into law by President Barack Obama in 2010.
The markets were jubilant. As the key piece of legislation introduced after the financial crisis to ensure that public money would not be needed to bailout the banks again, Dodd-Frank created the Financial Stability Oversight Council, introduced the ‘Volcker Rule’ prohibiting banks from funding speculative investments, and mandated the Dodd-Frank Act Stress Tests (DFAST) regime (in addition to numerous other rules and procedures).
So far, the only part of Dodd-Frank that the Trump administration has made it clear that it wants to ‘kill’ is the Volcker Rule. But the expectation is of sweeping change. Thus, the share price of the KBE Exchange Traded Fund, which specialises in the banking industry, has risen almost 30% since Trump’s election. Another important factor in the buoyant state of the markets was the announcement on 10 February that one the Federal Reserve’s most hawkish regulators, Daniel Tarullo, intended to step down early from his position, clearing the way for the Fed’s wings to be clipped.
Whilst Trump’s intention to repeal post-crisis financial regulations has provoked widespread concern, the question of why the markets have responded so positively to the news has received less attention. The assumption is simply that financial firms dislike regulation, and so it is in their interest to see less of it.
This only vague sense of the consequences of Trump’s plan is understandable among the public given the notoriously complex nature of financial regulation. More interesting is the muted response of some scholars specialising in the policy area.
To put the issue in context, there was, for a number of years, optimism that the financial crisis had opened up a window of opportunity for fundamental regulatory reforms. Some of this optimism was speculative in nature, underwritten by a hope that the public outcry at the bailout of the banks might break regulators’ attachment to models such as ‘Value-at-Risk’ and their encouragement of ever-increasing market complexity.
For others, it was the ‘macroprudential ideational shift’ – a newfound concern with systemic risk in the financial sector as a whole – that was the great hope. Andrew Baker became the most outspoken proponent of this view, seeing macroprudentialism as a policy paradigm shift signalling an abandonment of the efficient markets hypothesis and loosening the grip of neoliberalism on the regulatory imagination.
However, much of this early enthusiasm soon dissipated. As it became clear that post-crisis regulation would focus on system-stabilising instruments rather than bringing about transformative change, scholars converged in seeing the reforms that did come to pass as watered-down and frustratingly incremental.
The failure to raise bank capital to levels recommended by economists; the failure to introduce financial transaction taxes; and the failure to curtail shadow banking and the fragile short-term funding model – all these compromises, among a litany of others catalogued by scholars, added up to a picture of a financial sector that has more or less got its way in ensuring the continuation of the status quo ante. The title of an article by Ranjit Lall, ‘From failure to failure: The politics of international banking regulation’, is exemplary of the academic community’s assessment of the regulatory response to the crisis.
So if post-crisis financial regulations have turned out to be such a disappointment, then why be exercised by the prospect of their repeal?
The famous horseshoe theory in political science argues that left and right meet at their extremes and arrive at a surprising consensus on many issues. A similar dynamic is evident in the politics of financial regulation. Today, the workhorse concept of academic critique of financial regulation is capture theory: the idea that regulatory agencies come to serve the interests of the financial sector rather than the public at large.
Since the crisis, there have been attempts to employ capture theory to propose policies that might improve financial regulation. But it remains the case that the concept’s origins in the work of the Chicago-school economist, George Stigler, was anti-regulatory in its intentions and a similar ambivalence pervades academic critique of regulatory reforms. Although scholarly criticisms of post-crisis regulation tend to be articulated from a position of wishing to see more and better regulations, they often miss the progress that has been made.
That has certainly been the case with respect to a practice I am currently researching: the annual and biennial regulatory stress tests run by the Federal Reserve, Bank of England and European Banking Authority. The tests are used for both macroprudential modelling of the financial system’s resilience as well as for the supervision of individual firms. The Fed’s and Bank of England’s tests also confer strong powers of regulatory sanction – failing a test can result in a bank being prohibited from increasing dividend payments and conducting share buybacks.
And yet, the tests, no doubt seeming like mere technocratic devices, have escaped the attention of most scholars (Paul Langley’s work on stress testing focuses only on its role in the governance of the financial crisis). On the rare occasion that the stress tests are mentioned in the social science literature, the results are either reported in an acritical way or the practice is simply dismissed as a symptom of regulators’ attachment to using quantitative wizardry to fine-tune bank capital requirements.
The result is a tacit alliance across the political spectrum. For instance, the libertarian financial economist, Kevin Dowd, cites the argument of Admati and Hellwig’s book, The Bankers’ New Clothes, on the need to vastly increase bank capitalization when dismissing the stress tests as little more than confidence-boosting public theatre. Vice versa, Admati has repaid the compliment by citing Dowd’s argument about the supposed flaws in the Bank of England’s stress testing programme in her article on the ‘missed opportunity’ of capital regulation.
That Dowd is coming from a strongly anti-regulatory perspective – indeed, seeking to unwind financial regulation in its entirety – and Admati is pushing for a radical regulatory reform, does not impede the mutually-reinforcing nature of their critiques.
My claim is that the agreement between Dowd and Admati is symptomatic of a more general problem with the way social scientists have approached post-crisis financial regulation. Rather than evaluate on their own terms the innovations introduced by central banks and regulatory bodies, there has been a tendency to hold them to the unrealistically high standard of what scholars would have liked to have seen happen after the financial crisis. Measured against such demanding criteria, it is not surprising that reality has fallen short.
This is not to say that scholars are wrong on a case by case basis to criticise the limits of post-crisis financial regulations. But in aggregate, the literature can encourage cynicism. As I put it in a recent article, we need to be aware that ‘our criteria for judging what counts as success [in financial regulation] can be subtly complicit with anti-regulatory rhetoric.’
Or worse, taking post-crisis regulatory innovations for granted can lead to a lack of understanding about the motivations for the current pushback against them. In the last year, there have been critical reports on the Fed’s Comprehensive Capital Analysis and Review (CCAR) stress testing programme by the Committee on Capital Markets Regulation, the U.S. Government Accountability Office and The Clearing House.
The latter report, in particular, shows why the Trump administration might be so keen to roll back Dodd-Frank and curtail the powers of the Fed. Through a quantitative analysis of the implicit capital ratio and capital allocation model prescribed by the CCAR, it shows that it is not international regulatory standards such as Basel III which have been driving higher U.S. bank capitalization over recent years, but the stress tests themselves.
According to Morgan Stanley, if Trump manages to wind down or curtail the stress tests, there could be up to $120 billion of ‘excess’ regulatory capital up for grabs for redistribution via dividend payments and share buybacks. That is to say, the very capital that regulators have made banks build up since the financial crisis in order to prevent another crisis.
To make sense of this unfolding politics and contribute to the public debate, I believe scholars will need to adopt a more balanced assessment of what has been achieved by post-crisis financial regulations on both sides of the Atlantic. It is imperative that we gain a better understanding of these innovations in order to clarify the stakes of the political battles looming on the near horizon.