Dodd-Frank: Wrong diagnosis, wrong prescription

Congressional Republicans have Dodd-Frank in their sights. That bill, passed in the wake of the financial crash of 2008-2009, was supposed to prevent a repeat of that calamity. According to the Star Tribune, “The 2010 Dodd-Frank law imposed the stiffest restrictions on big financial companies since the Great Depression.” Its repeal is likely to be painted as an example of the GOP looking after Big Business. But the main victims of Dodd-Frank were not big banks, but small ones. By clamping down on them, the Act has damaged American economic growth.

Wrong diagnosis, wrong prescription

Dodd-Frank was based on a false diagnosis of the causes of the financial crash. It blamed greedy bankers for forcing sub-prime loans on unsuspecting borrowers. When these loans went sour, the federal government had to step in to save them. Or so the story goes.

This is not what happened. Sub-prime mortgages were creations of the federal government. No well run business, with its bottom line to think about, would produce a product so dangerous. Instead, they were pushed by the federal authorities in the name of expanding home ownership. In 2008, the federal government, via Fannie Mae and Freddie Mac, the FHA, Veterans Administration, and Farm Credit Administration, held 76% of sub-prime mortgages.

But, following the diagnosis that banker’s greed was the root cause of the crisis, Dodd-Frank sought to regulate that greed away. The result was a hopeless morass of red tape and confusion. To give one example,

“(Dodd-Frank) set up something called a Consumer Financial Protection Bureau (CFPB). The Bureau has authority over all financial relationships with consumers. The law here says that you can be civilly liable if you make a loan that is abusive, but what is an “abusive” loan? It’s not defined by statute. The CFPB has said “We won’t define it by regulation. Instead, we will define it over time by prosecuting people, and eventually people will get the message of what an abusive loan is.”

Bank lending can never be risk free. But by increasing uncertainty, as such vaguely drafted legislation does, Dodd-Frank increases risk. This reduces bank lending for both corporate and personal borrowers.

Unintended effects

Dodd-Frank has hit small banks disproportionately. It imposes huge compliance costs which only larger institutions can afford. A welter of evidence suggests that small banks have struggled under this burden and reduced their activities. Indeed, Minnesota has lost a quarter of its community banks since Dodd-Frank.

As well as exacerbating the “too big to fail” problem, Dodd-Frank has starved small businesses of vital capital.While bigger businesses can access securities markets for capital, smaller businesses, particularly startups, use smaller banks.

This has an economic impact as small businesses are vitally important to the US economy. They create seven of every ten new jobs and employ just over half of the country’s private sector workforce. They have generated 64% of net new jobs over the past 15 years. They generate more than half of the non-farm private gross domestic product. But a lack of startup capital, coupled with other increased regulatory burdens, has crashed new business formation in America. According to CNN,

“Only 452,835 firms were born in 2014, according to the most recent U.S. Census data released in the past week. That’s well below the 500,000 to 600,000 new companies that were started in the U.S. every year from the late 1970s to the mid- 2000s”

Time to go

Dodd-Frank is a poorly conceived, designed, and implemented bit of legislation. It has made existing problems worse and created new ones. It is time to get rid of this growth killer.

John Phelan is an economist at Center of the American Experiment.