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Axing Dodd-Frank Could Put the Entire Financial System at Risk

Some economists are warning that axing Dodd-Frank could mean opening the door to a repeat of the 2008 financial crisis.
Image: Fearless Girl
The "Fearless Girl" statue faces "Charging Bull" on Lower Broadway in New York.Mark Lennihan / AP

Consumer advocates criticized House Republicans’ push to effectively defang the Consumer Financial Protection Bureau with a bill passed late last week, but some observers warn that the bill’s biggest threat is that it opens the door to a repeat of the 2008 financial crisis.

“It really undermines supervision and it really destroys a lot of other protections against ‘too big to fail,’” said Marcus Stanley, policy director at Americans for Financial Reform. “It goes through and comprehensively disempowers regulators and weakens systemic risk regulation in a huge range of areas.”

Mike Konczal, a fellow at the Roosevelt Institute, characterized the Financial CHOICE Act — which is likely to be scaled back in the Senate — as an opening volley that lays out Republican priorities for regulatory rollback. “It sets a tone for how the GOP views financial reform overall,” he said.

Republicans and banking interest groups have said that the Dodd-Frank act gives too much power to regulators. “[Dodd-Frank] grants the CFPB vague and sweeping authority to regulate large swaths of the economy… and the authority to impose substantial penalties on individuals and businesses,” senators Ben Sasse (R-NE) and Mike Lee (R-UT) wrote in a January letter to the incoming Trump administration.

Related: Why Republicans Want to Declaw the Nation's Consumer Watchdog

Supporters of the agency say that’s exactly the point. “One reason the CFPB was created is that before the crisis, consumer protection authority in the financial sphere was broken up into 11 different agencies,” Konczal said. “It encouraged a regulatory race to the bottom,” he said, creating a system of arbitrage that encouraged banks, pre-Great Recession, to seek out the most lenient regulator and engage in riskier practices.

The biggest risk in the Financial CHOICE Act is how it would deal with “too big to fail” institutions. After the financial crisis, Dodd-Frank created a bankruptcy alternative involving multiple financial regulators, the Orderly Liquidation Authority. That would be rolled back in favor of an enhancement to the bankruptcy code — a provision policy experts like Aaron Klein, a fellow at the Brookings Institution, said would be inadequate in the face of a crisis like the industry faced in 2008.

When most businesses file for bankruptcy, a financier will step up and keep the troubled firm solvent while the bankruptcy proceeds. But if a giant bank or insurance company fails, there’s a problem: “The bankruptcy code is not enough because it assumes somebody can provide debtor-in-possession financing… which works unless it’s the providers of that funding that are bankrupt,” Klein said.

“It was recognized that, during periods of high financial stress, even augmented bankruptcy procedures might not be enough to maintain a stable financial system,” former Federal Reserve chairman Ben Bernanke wrote earlier this year, making the argument in a Brookings Institution blog post that the collapse of Lehman Brothers and the cascading shocks it delivered to global financial markets proved the need for an alternative.

“Ordinary bankruptcy procedures were entirely inadequate for the situation. The bankruptcy judge in the Lehman case… had neither the tools nor the mandate to try to mitigate the effects of the failure on the financial system or the economy,” he said.

“The Orderly Liquidation Authority had broad bipartisan support,” said Cliff Stanford, partner and chair of the bank regulatory group at law firm Alston & Bird. “It was seen as an appropriate mechanism after what happened with Lehman,” he said, although he added that the provision hasn’t yet been tested in a financial crisis. “Real-world experiences and experiments with bailouts versus bankruptcy are still being studied,” he said.

Advocates acknowledge that the Orderly Liquidation Authority’s ability to act as a bulwark against a repeat of 2008 hasn’t been proven, but they argue that relying on the bankruptcy code could create a moral hazard. Anticipating that a crisis that would spook lawmakers into another taxpayer-funded bailout, banks — freed from regulations scuttled by the Financial CHOICE Act — would have both the means and the motivation to engage in risky practices.

“It would make banks more profitable, riskier and more likely to cause a real problem,” Konczal said.