Financial Regulation After COVID

By Autumn Engebretson
Student Intern

John Diamond, Ph.D.
Edward A. and Hermena Hancock Kelly Fellow in Public Finance

In response to COVID-19, Congress has implemented several economic relief measures to aid both businesses and individuals. In addition, the Federal Reserve has reopened many of the same liquidity and credit facilities that were implemented in response to the Great Recession of 2008. One relief measure, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, also loosens several restrictions implemented by the Dodd- Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), such as the authority for the FDIC to implement bank debt guarantee programs.

Dodd-Frank is intended to prevent a financial crisis from occurring again by placing restrictions on the financial and banking sectors. This included greater capital requirements and measures such as the Volker Rule, which “prohibits banking entities from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds.” [1] The intent was to reduce the probability that bank failures would have systemic impacts on the economy. In addition, the Federal Reserve is prevented from bailing out individual firms outside the financial sector, and the approval of the treasury secretary is needed to activate emergency lending powers. This broadens fiscal stimulus across private sector companies, and reduces some moral hazards (such as incentives for firms to use excessive leverage) by removing the possibility of an individual firm bailout.

In 2018, President Trump reduced some of the burdens placed on financial institutions by Dodd-Frank through the implementation of the Economic Growth, Regulatory Relief, and Consumer Protection Act.[2] The majority of this legislation targeted easing restrictions on regional banks and was supported by both Democrats and Republicans.

One of the most powerful arguments against Dodd-Frank is that it will lead to a reduction in liquidity in certain markets as banks will have less flexibility in filling market transactions. These problems arose in late 2019 as the repo market ground to a halt[3] and overnight rates shot up to nine percent.[4] The liquidity problems led the Fed to intervene and inject billions of dollars into the financial markets, well before the COVID-19 crisis. The increase in federal debt has reached very high levels and will only make liquidity problems more severe through the next two years and beyond. This raises questions regarding the proper stringency of Dodd-Frank capital requirements that further restrict market liquidity.

The Federal Reserve, although prohibited from bailing out specific companies, has successfully stimulated the economy through other means that have been effective, especially in supporting investor sentiment. From 2008 to 2012, the Federal Reserve increased their asset holdings from less than $1 trillion to nearly $3 trillion; from January 2020 to August 2020, the Federal Reserve’s asset holdings increased from just over $4 trillion to nearly $7 trillion, the largest increase in total assets in the history of the Federal Reserve.[5] These increases, along with the trillions of dollars of federal debt that have been accumulated will only make future liquidity problems worse in the course of the next few years. This raises significant questions regarding the proper stringency of Dodd-Frank capital requirements, especially given the different economic circumstances now relative to 2008.

Already, there have been significant benefits that have come from the March 2020 loosening of Dodd-Frank. It has allowed for banks to take on additional risk in their lending, providing quicker access to loan financing for smaller businesses. However, in the first iteration of loans, loopholes allowed for larger companies to gain access, and significant preference was given to companies that already had loans at specific banks, hindering the overall initial efficacy of the program. In many cases, it appeared that the Small Business Administration did not conduct throughout checks on the accuracy of loan filing.[6] Some of these loopholes and preferential treatment have since been remedied, and although it has provided substantial capital it has not been specific in targeting those companies most in need.

This period should cause us to consider some of the effects of legislation like Dodd-Frank during a crisis and how those measures assist in recovery. However, this period should not be thought of as a natural experiment of Dodd-Frank to see if measures like capital requirements were set high enough. Dodd-Frank was intended to prevent another financial crisis; the current economic contraction is something entirely different. Dodd-Frank was intended to prevent, not to weather, a financial crisis. Using it as evidence of a failed system in the midst of the COVID-19 crisis is ill-advised. However, we must be flexible as we exit this crisis. It is likely that as we shift to a “new normal”, it will be worth examining Dodd-Frank and the new structure of the financial system to alight to proper incentives.

Our current economic situation is not permanent, and laws should not be altered based on the idea that domestic shutdown will last forever. However, we should remain flexible as our economy recovers from this crisis and emerges as something different than before.

So far, the measures that the Federal Reserve has taken to increase liquidity and support credit markets have been effective, demonstrating both the immense effects that the Fed can have on the financial economy as well as the difficulties that the Federal Reserve faces in achieving its economic objectives. However, this massive amount of power should be reserved for situations of extreme crisis such as this one. Maintaining these powers in standard times gives the Federal Reserve undue power to artificially support the economy for political or other gain. Further, by continuing the loosening of Dodd-Frank and allowing banks to lend more rather than maintaining reserves, we may face future problems of overleveraging within the banking industry.

The current economic and health crisis that we find ourselves in is incredibly unique and unpredictable by any measure. It is important in this time that we take stock of the changes that the economy will face, both as a whole and within the banking industry, and how Dodd-Frank and its liquidity measures may have to be altered to best stabilize the sector. However, these changes must be made with the post-COVID economy in mind, not one of never-ending stimulus and stay-at-home orders.

[1] Board of Governors of the Federal Reserve System. (2020, January 30). Federal Reserve Board—Volcker Rule. BOARD OF GOVERNORS of the FEDERAL RESERVE SYSTEM. https://www.federalreserve.gov/supervisionreg/volcker-rule.htm

[2] Crapo, M. (2018, May 24). S.2155 – 115th Congress (2017-2018): Economic Growth, Regulatory Relief, and Consumer Protection Act (2017/2018) [Webpage]. https://www.congress.gov/bill/115th-congress/senate-bill/2155

[3] Axios: Bank Heads Warn of Looming Liquidity Crisis. (2019, October 21). Newsmax. https://www.newsmax.com/finance/streettalk/bank-heads-liquidity-crisis/2019/10/21/id/937990/

[4] Domm, P. (2019, September 18). Fed loses control of its own interest rate as it cut rates—’This just doesn’t look good’. CNBC. https://www.cnbc.com/2019/09/18/fed-loses-control-of-its-own-interest-rate-on-day-of-big-decision-this-just-doesnt-look-good.html

[5] Board of Governors of the Federal Reserve System (US). (2002, December 18). Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level. FRED, Federal Reserve Bank of St. Louis; FRED, Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/series/WALCL

[6] Meier, J.-M. A., & Smith, J. (2020). The COVID-19 Bailouts (SSRN Scholarly Paper ID 3585515). Social Science Research Network. https://doi.org/10.2139/ssrn.3585515