Don’t Repeal Dodd-Frank, but Don’t Crush the Banks Either

In the clamor of election rhetoric it is hard to make clear-headed judgments about what should be done to promote stronger economic growth and more jobs. One piece of the recovery puzzle is to make sure the financial sector can do its job. Political slogans calling for the repeal of the Dodd-Frank financial reform make no sense.

First, that is not going to happen when a few senators can block either new legislation or the repeal of existing legislation. Second, after the massive financial crisis, reforms to restrain excessive risk-taking were essential and Dodd-Frank made a good start on those reforms. At the same time, efforts to blame the entire crisis and the continuing slow economy on Wall Street are equally foolish. And the way the Dodd-Frank rules are being implemented threatens to hold back new lending. Some on the left, and even a few on the right, are calling for the break up of the big banks, under the illusion this huge disruption would help us get through the economic slump.

The Slow Growth Equation

The reasons growth is so slow three years after the economy hit bottom are cautious consumers (understandably so), the weakness in the housing market, and the reluctance of businesses to invest. Nonresidential fixed investment in the first half of 2012 was still below the level reached in 2007. Large businesses mostly have plenty of cash but are hesitant to invest in major new projects. Small and medium-sized enterprises, the ones that typically power employment growth, lack cash flow and face a tough environment for borrowing.

Recoveries can generate their own momentum but this recovery has never hit takeoff speed. An important piece of a stronger recovery is a stronger financial sector. We do not want a return to a speculative bubble, but the willingness to take reasonable risks helps economic growth. The American financial sector must provide fuel to finance business sector recovery.

In the financial crisis small banks, medium-sized banks and large banks got into difficulty. There is lots of blame to go around and good reasons for improved safety and soundness regulation. Once the election is over, it will be time for a thorough review of where the new Dodd-Frank rules are working and where they are not working.

A New Approach to Enforcement

Regulators have been overloaded by the task of implementing Dodd-Frank, so draft rule-making has been handed out to disparate groups with no coherent strategy for creating a regulatory and supervisory system that fosters both stability and economic growth. We want a safer regulatory system, but not every single rule has to be calibrated for maximum safety. Having both seat belts and airbags is good, probably, but seven different restraints would but make it hard to drive or hard to breath.

An important reason to provide breathing room to the financial sector is that it will have to greatly expand its role in lending. The housing market is finally showing signs of recovery after its long swoon. Residential construction is increasing and prices are stabilizing or even rising in some locations. Currently, most new mortgages and refi’s are provided through government-backed enterprises, Fannie, Freddie and the Home Loan Banks, but over the next several years there must be a transition to greater reliance on private-sector mortgage lending. In the long run, taxpayers should not be the main source of mortgage funds and guarantor of mortgages, as they are today. Over the coming years, the American financial sector must be ready to take on a much bigger role in mortgage lending.

The idea of breaking up the big banks today is nuts. Yes, many of them behaved badly and needed support from taxpayers. Yes, bankers were making a ton of money. But the Dodd-Frank proposals for higher capital standards and the creation of a “resolution authority” to wind down failing institutions (as well as a half dozen other provisions) have gone a long way to respond to those excesses. Small, medium and large banks all have a role to play, providing different services to different parts of the economy. Large banks have unique expertise and capability in market-making and serving multinational companies. Attempting to break up the big banks, with an inevitable multi-year legal struggle and climate of huge uncertainty, is just a really bad idea at the current time of fragile recovery.

Either a re-elected Obama administration or a new Romney administration will be in place come January. Here’s hoping that whichever it is, they will forget the slogans and apply good sense and good economics to implement a set of financial rules that will foster both recovery and safety.