Don’t Believe the Banks on Dodd-Frank

In his latest column, the Washington Post’s Robert Samuelson, who’s generally not big on big government, comes out pretty much in favor of the Dodd-Frank financial reform act, but expresses one major concern. He worries that by limiting the scope of Section 13(3) of the Federal Reserve Act, which is the part of the law allowing the Fed to be the “lender of last resort,” Dodd-Frank strangles banks’ willingness to lend and therefore strangles economic growth.

This is a fairly common criticism of ending “Too Big To Fail.” And it’s kinda, sorta true—but in the most myopic terms possible, and it misses the larger point about how our banking system works.

If you ignore for a moment the fact that the current implementation of Dodd-Frank does not, in fact, significantly tie the Fed’s hands—show me the woman who believes “Too Big To Fail” is a thing of the past—then Samuelson has a point. Banks do need to be able to guarantee to their investors that if something goes wrong, they’ve got an escape hatch. But why—and this is a question that Samuelson never raises—must the role of guarantor fall to the Fed?

The fact that banks need to convince their investors that they won’t go belly-up is the best argument out there for requiring banks to keep more capital reserves. (The Brown-Vitter bill, which was killed in Congress two weeks ago, would have required that banks with more than $500 billion in assets have 15 percent in capital reserves, which is about twice as much as they are required to have now.)

It’s the banks (and stockholders) who are making money from riskier bets; so shouldn’t it be the banks (and stockholders) that take a haircut if those risky bets tank? And that’s not just an argument made on the grounds of some sort of populist justice; that’s an argument based on aligning the incentive structure of the larger economy. If the banks and stockholders are unwilling to make risky bets because it’s their ass on the line, then that’s a pretty good indication that we shouldn’t really be making those bets to begin with, right?

Now, this is where Samuelson is kinda, sorta right again. It’s true that if banks are held responsible for their own bets, then their bets (and their willingness to lend) will get more conservative. And it’s true that if they’re betting and lending more conservatively, our economy may grow less rapidly in the short term. But if banks are making bets and loans that they actually think are safe, then the growth that does occur is much more likely to be stable and enrich more than merely the Wall Street traders, who generally take home the lions’ share of those short-term winnings. And, of course, an economy that grows responsibly is more likely to avoid spectacularly collapsing one afternoon—a situation that definitely contributes to long-term economic growth.

And anyway, I suspect Samuelson may be making kind of a moot point. The language in Dodd-Frank that attempts to declaw Section 13(3) of the Federal Reserve Act is so riddled with loopholes that, even if it were to be implemented as strongly as possible (which is unlikely), the Fed could probably step in and bailout whoever it wanted, whenever it wanted. There’s a reason, after all, that financial reformers are up in arms that “Too Big To Fail” is still the de facto law of the land.) The reformers know this, the banks know this. So pretending that banks aren’t lending because they’re fearful the Fed won’t bail them out if they get in above their heads? I’m not convinced.

Haley Sweetland Edwards

Haley Sweetland Edwards is an editor of the Washington Monthly.