On February 28, the Heritage Foundation issued a volume of essays by leading scholars on the law and economics of financial services regulatory reform entitled Prosperity Unleashed: Smarter Financial Regulation. This Report, which is well worth a read (in particular, by incoming Trump Administration officials and Members of Congress), is available online.
The Report’s 23 chapters, which deal with different aspects of financial markets, reflect 10 core principles:
- Private and competitive financial markets are essential for healthy economic growth.
- The government should not interfere with the financial choices of market participants, including consumers, investors, and uninsured financial firms. Regulators should focus on protecting individuals and firms from fraud and violations of contractual rights.
- Market discipline is a better regulator of financial risk than government regulation.
- Financial firms should be permitted to fail, just as other firms do. Government should not “save” participants from failure because doing so impedes the ability of markets to direct resources to their highest and best use.
- Speculation and risk-taking are what make markets operate. Interference by regulators attempting to mitigate risks hinders the effective operation of markets.
- Government should not make credit and capital allocation decisions.
- The cost of financial firm failures should be borne by managers, equity-holders, and creditors, not by taxpayers.
- Simple rules—such as straightforward equity capital requirements—are preferable to complex rules that permit regulators to micromanage markets.
- Public-private partnerships create financial instability because they create rent-seeking opportunities and misalign incentives.
- Government backing for financial activities, such as classifying certain firms or activities as “systemically important,” inevitably leads to government bailouts.
The chapters deal with these specific topics (the following summary draws upon the introduction to the Report):
Chapter 1, “Deposit Insurance, Bank Resolution, and Market Discipline,” explains how government-backed deposit insurance weakens market discipline, increases moral hazard, and leads to higher financial risk than the economy would have otherwise, thus weakening the banking system as a whole.
Chapter 2, “A Simple Proposal to Recapitalize the U.S. Banking System,” follows with a brief look at the failure of the Basel rules and a discussion of how banks’ historical capital ratios—a key measure of bank safety—have fallen as regulations have increased. The author proposes a regulatory off-ramp, whereby banks could opt out of the current regulatory framework in return for meeting a minimum leverage ratio of at least 20 percent.
Chapter 3, “A Better Path for Mortgage Regulation,” provides a brief history of federal mortgage regulation. This essay shows that, prior to Dodd–Frank, the preferred federal policy was to protect mortgage borrowers through mandatory disclosure as opposed to directly regulating the content of mortgage agreements. The author argues that the vibrancy of the mortgage market has suffered because the basic disclosure approach has succumbed to regulation via content restrictions.
Chapter 4, “Money and Banking Provisions in the 2016 Financial CHOICE Act: A Major Step Toward Financial Security,” evaluates the reforms in the CHOICE Act, the first major piece of legislation written to replace large portions of the Dodd–Frank Wall Street Reform and Consumer Protection Act (a far-reaching statute whose provisions are at odds with its name). The author discusses the CHOICE Act’s regulatory off-ramp—and one potential alternative—because a similar approach could be used to implement a broad set of bank regulation reforms.
Chapter 5, “Securities Disclosure Reform,” delves into the law and economics of mandatory disclosure requirements, both in connection with new securities offerings and ongoing disclosure obligations. The author explains that disclosure requirements have become so voluminous that they obfuscate rather than inform, making it more difficult for investors to find relevant information.
Chapter 6, “The Case for Federal Pre-Emption of State Blue Sky Laws,” recommends improving the efficiency and effectiveness of capital markets through federal pre-emption of state securities “blue sky” laws, which impose state registration requirements on companies seeking to issue securities. Blue sky laws inefficiently retard the flow of capital from investors to businesses.
Chapter 7, “How to Reform Equity Market Structure: Eliminate ‘Reg NMS’ and Build Venture Exchanges,” tackles the seemingly opaque topic of U.S. equity market structure. The essay argues that the increasingly fragmented structure of today’s equities markets has been shaped as much, if not more, by legislative and regulatory action than by the private sector. The author calls on the Securities and Exchange Commission (SEC) to consider rescinding Reg NMS and replacing it with rules (and rigorous disclosure requirements) that allow free and competitive markets to dictate much of market structure.
Chapter 8, “Reforming FINRA,” explains that FINRA, the primary regulator of broker-dealers, is neither a true self-regulatory organization nor a government agency, and that FINRA is largely unaccountable to the industry or to the public. The chapter broadly outlines alternative approaches that Congress and the regulators can take to fix these problems, and it recommends specific reforms to FINRA’s rule-making and arbitration process.
Chapter 9, “Reforming the Financial Regulators,” argues that financial regulation should establish a framework for financial institutions based on their ability to serve consumers, investors, and Main Street companies. This view is starkly at odds with the current “macroprudential” trend in financial regulation, which places governmental regulators—with their purportedly greater understanding of the financial system—at the top of the decision-making chain.
Chapter 10, “The World After Chevron,” discusses the Supreme Court’s decision in Chevron U.S.A. Inc. v. Natural Resources Defense Council, a case that has generated considerable controversy among policymakers over the past decade. The Chevron decision effectively transferred final interpretive authority from the courts to the agencies in any case where Congress did not itself answer the precise dispute. Reform-minded policymakers have long called on Congress to return that ultimate decision-making authority to the federal courts.
Chapter 11, “Transparency and Accountability at the SEC and at FINRA,” describes how these two regulatory bodies—the two mostly responsible for governing the U.S. securities sector—lack the structural safeguards necessary to ensure that they exercise their authority with the consent of the American public. The chapter provides recommendations for fixing these deficiencies, such as giving respondents a choice of federal court or administrative proceedings with the SEC, and allowing FINRA to exist as a purely voluntary, private industry association.
Chapter 12, “The Massive Federal Credit Racket,” provides an extensive list of the more than 150 federal credit programs that provide some form of government backing. These programs consist of direct loans and loan guarantees for housing, agriculture, energy, education, transportation, infrastructure, exporting, and small businesses, as well as insurance programs to cover bank and credit union deposits, pensions, flood damage, crop damage, and acts of terrorism. Government financing programs are often sold to the public as economic imperatives, particularly during downturns, but they are instruments of redistributive policies that mainly benefit those with the most political influence rather than those with the greatest need.
Chapter 13, “Reforming Last-Resort Lending: The Flexible Open-Market Alternative,” proposes a plan to reform the Federal Reserve’s means for preserving liquidity for financial as well as nonfinancial firms, especially during financial emergencies, but also in normal times. The essay proposes, among other things, to replace the existing Fed framework with a single standing (as opposed to temporary) facility to meet extraordinary as well as ordinary liquidity needs as they arise. The goal is to eliminate the need for ad hoc changes in the rules governing the lending facility, or for special Fed, Treasury, or congressional action.
Chapter 14, “Simple, Sensible Reforms for Housing Finance,” advocates establishing a national title database to prevent the sort of clerical errors that plagued the foreclosure process during the housing crash of 2007 to 2009. The author also recommends eliminating government support for all mortgages with low down payments, and for refinancing loans that increase the borrower’s mortgage debt. Both types of loans encourage households to take on debt rather than accumulate wealth.
Chapter 15, “A Pathway to Shutting Down the Federal Housing Finance Enterprises,” provides an overview of all the federal housing finance enterprises and argues that Congress should end these failed experiments. The federal housing finance enterprises, cobbled together over the last century, today cover more than $6 trillion (60 percent) of the outstanding single-family residential mortgage debt in the United States. Over time, the policies implemented through these enterprises have inflated home prices, led to unsustainable levels of mortgage debt for millions of people, cost federal taxpayers hundreds of billions of dollars in bailouts, and undermined the resilience of the housing finance system.
Chapter 16, “Fixing the Regulatory Framework for Derivatives,” discusses government preferences for derivatives and repurchase agreements (repos)—an often ignored but integral part of the many policy problems that contributed to the 2008 crisis. As the essay explains, the main problem with the pre-crisis regulatory structure for derivatives and repos was that the bankruptcy code included special exemptions (safe harbors) for these financial contracts. The safe harbors were justified on the grounds that they would prevent systemic financial problems, a theory that proved false in 2008. The chapter concluded that eliminating all safe harbors for repos and derivatives would affect the market because counterparties would have to account for more risk, a desirable outcome.
Chapter 17, “Designing an Efficient Securities-Fraud Deterrence Regime,” explains that the main flaws in the current approach to securities-fraud deterrence in the U.S., and recommends several reforms to fix these problems. This essay recommends that the government should credibly threaten individuals who would commit fraud with criminal penalties, and pursue corporations only if their shareholders would otherwise have poor incentives to adopt internal control systems to deter fraud.
Chapter 18, “Financial Privacy in a Free Society,” stresses the importance of maintaining financial privacy—a key component of life in a free society—while policing markets for fraudulent (and other criminal) behavior. The current U.S. financial regulatory framework has expanded so much that it now threatens this basic element of freedom. For instance, individuals who engage in cash transactions of more than a small amount automatically trigger a general suspicion of criminal activity, and financial institutions of all kinds are forced into a quasi-law-enforcement role. The chapter recommends seven reforms that would better protect individuals’ privacy rights and improve law enforcement’s ability to apprehend and prosecute criminals and terrorists.
Chapter 19, “How Congress Should Protect Consumers’ Finances,” provides an overview of consumer financial protection law, and then provide several recommendations on how to modernize the consumer financial protection system. The goal of these reforms is to fix the federal consumer financial protection framework so that it facilitates competition, consumer protection, and consumer choice. The authors recommend transferring all federal consumer protection authority to the Federal Trade Commission, the agency with vast regulatory experience in consumer financial services markets.
I will have a bit more to say about my co-authored contribution, “How Congress Should Protect Consumers’ Finances,” in my next post.
Chapter 20, “Reducing Banks’ Incentives for Risk-Taking via Extended Shareholder Liability,” examines changes in shareholder liability that could better align incentives and reduce the moral hazard problems that result in excessively risky financial institutions. The authors describe how under extended liability, an arrangement common in banking history, shareholders of failed banks have an obligation to repay the remaining debts to creditors.
Chapter 21, “Improving Entrepreneurs’ Access to Capital: Vital for Economic Growth,” shows how existing rules and regulations hinder capital formation and entrepreneurship. The essay explains that several groups usually support the current complex, expensive, and economically destructive system because excessive regulation helps keep their competitors at bay. The author describes more than 25 policy reforms to reduce or eliminate state and federal regulatory barriers that hinder entrepreneurs’ access to capital.
Chapter 22, “Federalism and FinTech,” provides an in-depth look at how financial technology or “FinTech” companies are beginning to utilize advances in communications, data processing, and cryptography to compete with traditional financial services providers. Some of the most powerful FinTech applications are removing geographic limitations on where companies can offer services and, in general, lowering barriers to entry for new firms. As the essay explaints, this newly competitive landscape is exposing weaknesses, inefficiency, and inequity in the U.S. financial regulatory structure.
Chapter 23, “A New Federal Charter for Financial Institutions,” proposes a new banking charter under which a financial institution would be regulated more like banks were regulated before the modern era of bank bailouts and government guarantees. Under the proposed charter, which is similar to a regulatory off-ramp approach, banks that choose to fund themselves with higher equity would be faced mostly with regulations that focus on punishing and deterring fraud, and fostering the disclosure of information that is material to investment decisions. The charter explicitly includes a prohibition against receiving government funds from any source, and even excludes the financial institution from FDIC deposit insurance eligibility.
In conclusion, Prosperity Unleashed sets forth the elements of a legislative and regulatory reform agenda for the financial services sector, which has the potential for stimulating economic growth and innovation while benefiting consumers and businesses alike. I will have a bit more to say about my co-authored contribution, “How Congress Should Protect Consumers’ Finances,” in my next post.