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Financial Regulation

The Issue

Seven years after the financial collapse of 2008, the policy failures that it revealed still have not been resolved. The Dodd–Frank Wall Street Reform and Consumer Protection Act, hurriedly enacted in 2010, does little to address these failures, and in many ways makes things worse. Dodd–Frank is based on a mistaken belief that the 2007–2009 financial crisis stemmed from unregulated financial markets. This is a false narrative. Research has shown that there has been no substantial reduction in U.S. financial regulations during the past 100-plus years.

Many parts of Dodd–Frank, ranging from price controls on debit cards to the creation of a new bureaucracy for consumer financial “protection,” have little to do with the financial crisis. Even where the legislation addresses the relevant problem, it misses the mark.

No issue in financial policy is more critical or more vexing than “too big to fail”—the concept that some firms are so important to the financial system that the government must intervene with bailouts or other support rather than let them go through the bankruptcy process. Instead of eliminating this doctrine, the Dodd–Frank Act reinforces it. A far better approach would be to establish bankruptcy provisions that minimize the impact on the economy if a critical private institution fails.

Perhaps Dodd–Frank’s greatest weakness is that it completely neglected to address Fannie Mae and Freddie Mac, the two government-created mortgage finance giants whose activities helped to create and exacerbate the 2008 financial collapse. Fannie Mae and Freddie Mac issued trillions of dollars in mortgage-backed securities and, responding in part to congressionally mandated purchase requirements, speculated in their own securities and those issued by others. Full recovery from the housing crisis will not be possible until both Fannie Mae and Freddie Mac are phased out and replaced by a private-sector housing-finance system.

In contrast to these regulatory overreaches, the 2012 Jumpstart Our Business Startups (JOBS) Act reduced regulatory impediments to entrepreneurial capital formation. It reduced the regulatory burden on most newly public companies for their first five years as a public company. Effective June 2015, it expanded the ability of small issuers to raise up to $50 million in capital annually; allowed private companies to use the Internet or newspapers to raise money from affluent investors and financial institutions; and created a crowd-funding exemption.


Eliminate the Financial Stability Oversight Council (FSOC). The authors of Dodd–Frank claimed to have eliminated the pernicious too-big-to-fail policy, but they actually strengthened it. In particular, Title I of the Dodd–Frank Act created the FSOC, a multi-regulator council with an ill-defined mandate of constantly monitoring and improving financial stability. The FSOC enshrines the too-big-to-fail problem because it identifies firms whose failure regulators believe would cause a financial crisis; it singles out so-called systemically important financial institutions (SIFIs) for special regulations. The FSOC’s very existence increases the likelihood of future financial crises and bailouts.

Repeal Orderly Liquidation Authority (OLA). Title II of Dodd–Frank created OLA, a new avenue for federal bailouts. While orderly liquidation sounds pleasant, Dodd–Frank’s OLA allows federal regulators to seize troubled financial firms—with minimal judicial review—and close down their affairs. As part of OLA, the Federal Deposit Insurance Corporation (FDIC) is authorized to hold taxpayers responsible for the most worthless assets on a company’s books. This OLA process is recognized as a bailout because firms can be forced into OLA only after the FDIC and the Federal Reserve certify that there are no private-sector options for saving the company. The time-tested bankruptcy system, with its legal protections and judicial supervision, is a far better system. OLA should be replaced by a streamlined process under the bankruptcy laws to provide a judicial proceeding delimited by the rule of law.

Fully Repeal Dodd–Frank’s Title X. Title X of Dodd–Frank created the Consumer Financial Protection Bureau (CFPB) under the false premise that consumers were unprotected against fraud and other misdeeds. Dodd–Frank granted the new agency unparalleled rulemaking, supervisory, and enforcement powers over virtually every consumer financial product and service. As currently structured, the CFPB unduly restricts access to credit without meaningful oversight from Congress or the executive branch. In effect, the CFPB can dictate the types of financial products and services available to consumers instead of allowing them to exercise choice. The CFPB’s paternalistic view of consumers means fewer choices and higher costs for credit. If Congress repeals Title X and maintains remnants of the CFPB, Congress should ensure that the new agency’s funding structure is under the regular appropriations process, that the new agency only enforces existing federal consumer protection laws, and that the new agency has a director who is removable at will by the President.

Repeal the Volcker Rule. Section 619 of the Dodd–Frank Act required federal regulators to implement what is known as the Volcker Rule. This rule prohibits banks, with certain exceptions, from engaging in proprietary trading. The idea is to limit banks’ ability to make securities trades solely for their own account rather than for their customers. Partly due to the difficulty in distinguishing between proprietary trading and providing trading opportunities for customers (market making), the final rule includes exemptions for certain activities. Although it seems logical to stop federally insured banks from making risky bets, every commercial loan is a risky bet on whether the borrower will repay the loan. Although some aspects of commercial lending may seem safer than short-term securities trading, commercial lending typically creates more liquidity risk than securities trading. It runs wholly counter to the conventional narrative surrounding the 2008 financial crisis, but federal regulators already regulated proprietary trading (they actually had, and used, the authority to do so ever since 1933).

Repeal Title VII of Dodd–Frank and Remove Bankruptcy Preferences for Derivatives. Title VII completely restructured the regulatory framework of the over-the-counter (OTC) derivatives market based on the false notion that a lack of regulation caused the financial crisis. The bulk of the pre-crisis OTC derivatives market was deeply concentrated among heavily regulated commercial banks. Title VII represents a gift to these banks because its OTC clearing mandate transfers banks’ counterparty risks to specialty clearing firms. The main problem with the pre-crisis regulatory structure for derivatives was that the bankruptcy code included special exemptions (safe harbors) for derivatives. These safe harbors from core bankruptcy provisions gave derivative users preferred positions relative to other types of creditors, and all such preferences should be eliminated.

Repeal Title VIII of Dodd–Frank. Title VIII of Dodd–Frank magnifies the too-big-to-fail problem by conferring a special status on specialty clearing companies. These firms, identified as financial market utilities (FMUs), are the Title VIII counterpart to the so-called SIFIs, which Title I of Dodd–Frank addresses. Title VIII provides these companies with direct access to Federal Reserve lending, creating more moral hazard and further undermining financial stability. Title VIII is a clear admission that the Title VII clearing mandate undermines financial stability. Congress should repeal both Title VII and Title VIII of Dodd–Frank.

Eliminate Federal Credit Subsidies, Guarantees, and Insurance. Americans collectively shoulder more than $18 trillion in debt exposure from loans, loan guarantees, and subsidized insurance provided by some 150 federal programs. This redistribution of taxpayers’ money erodes the nation’s entrepreneurial spirit, increases financial risk, and fosters cronyism and corruption. Losses are dispersed among millions of taxpayers, and the programs and subsidies have given rise to powerful constituencies of beneficiaries. The government credit portfolio consists of direct loans and loan guarantees for housing, agriculture, energy, education, transportation, infrastructure, exporting, and small business, among other enterprises. Federal insurance programs cover bank and credit union deposits, pensions, flood damage, declines in crop prices, and acts of terrorism. Capital for mortgage lending by banks is provided by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac. Federally backed deposit insurance creates similar distortions and risks, and Congress should immediately reduce federal deposit insurance coverage to the pre-savings-and-loan crisis limit of $40,000, a figure that is well above the average account holder’s balance. Congress should also ensure that coverage is provided on an individual basis, and limit the total deposit insurance coverage of any one bank to 5 percent of total insured deposits. Congress should ultimately phase out government-backed deposit insurance along with all other credit subsidies, guarantees, and insurance.

Replace Federal Reserve Emergency Lending with Expanded Open Market Liquidity Auctions. A stated purpose of Title XI of Dodd–Frank was to protect taxpayers by restricting the Federal Reserve’s ability to provide emergency loans. Many of the changes instituted by Title XI aimed to force the Fed to adhere to the classic prescription for a lender of last resort (LLR), developed in the 19th century. However, even the classic LLR prescription is a second-best solution to private banks (under the threat of failure) providing all of the lending that markets need. Thus, the classic LLR prescription is a flawed concept upon which to base emergency loan restrictions. Congress should allow the Fed to provide system-wide liquidity on an ongoing basis, rather than allocating credit to specific firms on an ad hoc basis. Emergency lending authority is unnecessary for conducting monetary policy. Congress should replace the Fed’s existing primary dealer system with a single standing facility to meet extraordinary as well as ordinary liquidity needs. This change would help eliminate the need, during a crisis, for ad hoc changes in the rules governing the facility, or for special Fed, Treasury, or congressional action. These changes would make Fed lending to insolvent institutions unnecessary.

Provide an Off-Ramp-Style Federal Financial Charter. U.S. banks and non-bank financial firms are extensively regulated. While banks are more heavily regulated than other financial firms, virtually all financial companies are subject to extensive restrictions on their activities, capital, and asset composition. Simultaneously, in the name of ensuring stability, U.S. taxpayers have absorbed more of the financial losses due to risks taken by private market participants. This combination of policies has produced a massive substitution of government regulation for market competition, which culminated in the 2008 financial crisis. Fixing this framework requires rolling back both government regulation and taxpayer backing of financial losses, making it possible for private citizens to build a stronger financial system that directs capital to its most valued uses. Creating a new federal charter for financial institutions, which relieves the regulatory burden for those who absorb more of their financial risks, would help achieve these goals.

Eliminate Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac, the government-sponsored mortgage giants, should be shut down completely and permanently. Both entities distort the market by issuing mortgage-backed securities with subsidized government guarantees. If such guarantees are necessary, they should be priced and issued by the private sector. Congress should take steps to liquidate Fannie and Freddie’s mortgage portfolio and ensure that they are not simply replaced by a new government-sponsored agency. Federal policies implemented through these government-sponsored enterprises (GSEs) have made housing more expensive and increased Americans’ risky debt. To begin winding down the GSEs, they should be prohibited from purchasing mortgages for non-owner-occupied homes or for “cash out” refinances. Congress should also ensure that the GSEs only purchase smaller loans and charge higher guarantee fees, and that bank capital requirements no longer provide preferences to the GSEs’ mortgage-backed securities. Finally, Congress should lift federal content restrictions on mortgages, as they are not conducive to a vibrant and competitive lending market.

Reduce Regulatory Impediments to Capital Formation. Congress should remove regulatory impediments that limit entrepreneurs’ access to the capital they need to launch and grow new businesses. Congress should preserve the existing thresholds for private offerings and expand the ability of sophisticated investors to invest in private offerings, as well as establish venture exchanges. Current law allows large public companies to raise capital without having to deal with 50 different expensive and time-consuming state registration and qualification requirements. Congress should allow smaller public companies and other smaller companies with extensive federal disclosure requirements to also be free of this burden. Congress should replace the 14-plus different categories of securities-issuing firms (as described by the existing rules) with three disclosure regimes—public, quasi-public, and private. Just as important, Congress should replace the current complex and arbitrary federal disclosure system with a reasonable, coherent, and scaled disclosure system that imposes increasing requirements as companies grow and have more shareholders with more capital at risk. Finally, it is time to create a micro-offering exemption that allows very small private companies to raise capital without having to comply with complex Securities and Exchange Commission rules.

Reform and Consolidate Financial Regulators. Several key structural, procedural, and policy reforms would produce more effective financial regulation by making financial market participants, including regulators, more accountable for their actions. Congress should subject financial regulators to appropriations and implement a commission governing structure for all financial regulators. Congress should also consolidate related powers in one regulator, remove authorities from agencies ill-equipped to perform them, and revamp processes to ensure appropriate accountability for, and public input in, rulemaking. Ideally, Congress would merge existing agencies and create only one federal banking regulator and one capital markets regulator. In the process, Congress should remove the Federal Reserve entirely from regulation and supervision.

Design an Efficient Securities-Fraud Deterrence Regime. For capital markets to function well, investors need accurate information about securities. If investors do not trust firms’ disclosures, they will discount what they are willing to pay for securities, increasing the cost of capital and thereby making it more difficult, even for honest firms, to fund productive endeavors. Deterring fraud in the capital markets should be a government priority, but the current U.S. approach to securities-fraud deterrence falls far short of the ideal. Congress should implement a system that: (1) places more emphasis on individual liability; (2) eschews corporate criminal penalties entirely; (3) focuses the imposition of corporate civil penalties on companies whose shareholders would otherwise have few incentives to adopt internal control systems for deterring fraud; (4) limits private enforcement to traditional common law remedies or other compensatory remedies with similar safeguards against over-deterrence; and (5) better delineates and coordinates the authority of federal and state securities-fraud enforcers.


Facts and Figures

FACT: Deregulation did not cause the 2008 financial collapse.

  • From the supposed deregulation in 1999 and 2000, until the Lehman Brothers failure in 2008, financial regulators issued 7,100 pages of regulations.
  • These regulations implemented more than 800 separate rules.

FACT: Dodd–Frank doubled down on attempting to prevent a financial crisis by issuing an excessive number of financial regulations.

  • Between the enactment of Dodd–Frank in July 2010 and July 2016, regulators added 16,169 pages of financial regulations to the Federal Register.
  • Dodd–Frank required regulators to implement approximately 400 separate rules.

FACT: Poorly designed government policies led to the 2008 financial collapse.

  • So-called affordable housing goals, implemented through government-sponsored enterprises (GSEs), have led to steady increases in mortgage debt of single-family residences, and the GSEs hold nearly $6 trillion in this debt, meaning that taxpayers are responsible for billions of dollars in potential losses.
  • The Fannie Mae loan limit for single-family homes steadily increased, from $93,750 in 1980 to $729,750 in 2008, allowing the GSEs to fund excessive borrowing for homes.
  • In 1989, before the GSEs expanded with these affordable housing goals, nearly 90 percent of U.S. housing markets were rated as affordable, with a median home price to median income ratio of 3.0 or less.
  • By 2006, after more than a decade of GSE expansion to make housing more affordable, the GSE model had clearly failed. The median house price nationally increased from 2.86 times the median income at the end of 1992 to 4.05 times the median income in 2006. Housing had become less affordable.
  • In 1934, the FDIC only covered $2,500 per depositor, but it has steadily risen over the years to $250,000 in 2008, and expanded to include wholesale funding so that the limit is virtually meaningless. This expansion has increased moral hazard, thus increasing risky borrowing.
  • Lehman Brothers’ problems were exacerbated by harmful bankruptcy rules for derivatives. Immediately before the firm collapsed, J.P. Morgan was able to seize $17 billion in securities and cash (Lehman’s collateral), and then demanded an additional $5 billion payment.
  • Special bankruptcy safe harbors induced firms to rely more heavily on derivatives and repurchase agreements (repos) than they would have in absence of the special protections. Data show that the portion of total investment bank assets financed by repos doubled between 2000 and 2007. The market would not have supported such high increases in leverage without the special protections.

Selected Additional Resources

David R. Burton, “Building an Opportunity Economy: The State of Small Business and Entrepreneurship,” testimony before the Committee on Small Business, U.S. House of Representatives, March 4, 2015.

David R. Burton, “Don’t Crush the Ability of Entrepreneurs and Small Businesses to Raise Capital,” Heritage Foundation Backgrounder No. 2874, February 5, 2014.

David R. Burton, “Legislative Proposals to Enhance Capital Formation and Reduce Regulatory Burdens: Venture Exchanges,” testimony before the Capital Markets and Government Sponsored Enterprises Subcommittee, Committee on Financial Services, U.S. House of Representatives, May 13, 2015.

David R. Burton, “Proposals to Enhance Capital Formation for Small and Emerging Growth Companies,” testimony before the Capital Markets and Government Sponsored Enterprises Subcommittee, Committee on Financial Services, U.S. House of Representatives, April 11, 2014. ]

James L. Gattuso, “Breaking Up Big Banks: Right Question, Wrong Answer,” Heritage Foundation Issue Brief No. 3906, April 10, 2013.

Diane Katz, “The CFPB in Action: Consumer Bureau Harms Those It Claims to Protect,” Heritage Foundation Backgrounder No. 2760, January 22, 2013.

Diane Katz, “Dodd–Frank at Year Three: Onerous and Costly,” Heritage Foundation Issue Brief No. 3993, July 19, 2013.

Diane Katz, “Reforming Consumer Financial Protection Bureau Necessary to Protect Consumers,” Heritage Foundation WebMemo No. 3216, April 7, 2011.

Norbert J. Michel, ed., The Case Against Dodd-Frank: How the “Consumer Protection” Law Endangers Americans (Washington, DC: The Heritage Foundation, 2016).

Norbert J. Michel, “The Fed’s Failure as a Lender of Last Resort: What to Do About It,” Heritage Foundation Backgrounder No. 2943, August 20, 2014.

Norbert J. Michel, “Financial Market Utilities: One More Dangerous Concept in Dodd–Frank,” Heritage Foundation Backgrounder No. 3005, March 20, 2015.

Norbert J. Michel, “Financial Stability Oversight Council and Asset Management Firms,” Heritage Foundation Issue Brief No. 4215, May 6, 2014.

Norbert J. Michel, “The Financial Stability Oversight Council: Helping to Enshrine ‘Too Big to Fail',” Heritage Foundation Backgrounder No. 2900, April 1, 2014.

Norbert J. Michel, “Fixing the Dodd–Frank Derivatives Mess: Repeal Titles VII and VIII,” Heritage Foundation Backgrounder No. 3076, November 16, 2015.

Norbert J. Michel, “Lehman Brothers Bankruptcy and the Financial Crisis: Lessons Learned,” Heritage Foundation Issue Brief No. 4044, September 12, 2013.

Norbert J. Michel, ed., Prosperity Unleashed: Smarter Financial Regulation (Washington, DC: The Heritage Foundation, 2017).

Norbert J. Michel, “Repealing Dodd–Frank and Ending ‘Too Big to Fail',” Heritage Foundation Backgrounder No. 2973, November 3, 2014.

Norbert J. Michel and Tamara Skinner, “The Popular Narrative About Financial Deregulation Is Wrong,” The Daily Signal, July 29, 2016.

Selected References from Norbert J. Michel, ed., Prosperity Unleashed: Smarter Financial Regulation (Washington, DC: The Heritage Foundation, 2017).

Mark Calabria, Norbert J. Michel, and Hester Peirce, “Reforming the Financial Regulators.”

Rutheford Campbell Jr., “The Case for Federal Pre-Emption of State Blue Sky Laws.”

Gerald Dwyer and Norbert J. Michel, “A New Federal Charter for Financial Institutions.”

Daniel Gallagher, “How to Reform Equity Market Structure: Eliminate ‘Reg NMS’ and Build Venture Exchanges.”

Diane Katz, “The Massive Federal Credit Racket.”

Arnold Kling, “Simple, Sensible Reforms for Housing Finance.”

Thaya Knight, “Transparency and Accountability at the SEC and at FINRA.”

John L. Ligon, “A Pathway to Shutting Down the Federal Housing Finance Enterprises.”

Norbert J. Michel, “Fixing the Regulatory Framework for Derivatives.”

Amanda Rose, “Designing an Efficient Securities-Fraud Deterrence Regime.”

George Selgin, “Reforming Last-Resort Lending: The Flexible Open-Market Alternative.”