Banking and Financial Markets

Financial markets are critical to economic growth and prosperity here and around the world. They facilitate payments, bring together people who have money to invest with those who can put the money to use, and they allow people to manage their risks. The financial system enables entrepreneurs to undertake innovative ventures and expand existing ones. It also makes funds available to average consumers who want to buy homes or cars, meet an emergence need, or finance their children’s education.

A poor regulatory framework can impede the financial system’s ability to meet the needs of businesses and consumers. Many reforms in the wake of the financial crisis are examples of regulations that impede—rather than facilitate—economic growth. Recent reforms give regulators greater power to make decisions about how the financial system functions, what types of products and services it offers, and who it serves. The regulators making these decisions are not acquainted with the unique needs of consumers and companies. Moreover, in their well-intentioned attempts to make the financial system more stable, regulators introduce new risks into the financial system.

Through the lens of free-market economics, political economy, institutional analysis, and administrative law, the Financial Markets Working Group at the Mercatus Center at George Mason University analyzes each of the research areas below. Based on a rigorous research and review processes, it has observed that the enhanced powers given to regulators to control the financial markets limits consumers’ access to credit, entrepreneurs’ access to funding, and ultimately creates a less robust financial system that is more vulnerable to shocks.

The Financial Markets Working Group seeks to identify market-based alternatives to the currently favored regulator-centric approaches. Market-based approaches to regulation will enhance the vibrancy, stability, and efficacy of our financial markets.

CONTENTS
Housing and Government-Sponsored Enterprises 
Consumer Finance
The Consumer Financial Protection Bureau 
The US Financial System
Responsible Rulemaking for Federal Financial Regulators 

HOUSING AND GOVERNMENT-SPONSORED ENTERPRISES
A government-sponsored enterprise (GSE) is a financial services corporation created by Congress with the express intention of increasing the flow of credit to targeted sectors of the economy.

Federal housing and mortgage finance policies contributed to the 2008 financial crisis and require more substantial systematic reform to restore market discipline to the housing sector.

• GSE legislation enacted in 1992 explicitly included a goal of supporting “affordable housing.” In issuing regulations to implement this legislation, the US Department of Housing and Urban Development (HUD) set goals that led the GSEs to equate “affordable housing” with low-down-payment lending and lending to borrowers with poor credit histories These policies helped fuel an increase in demand, which contributed to a massive increase in housing prices.

These federal policies didn’t just contribute to the financial crisis; they saddled taxpayers with a load of debt. We need to rescue future generations from this debt and wind down the biggest culprits, Fannie Mae and Freddie Mac.

• By the end of 2009, Fannie and Freddie’s total debt and mortgage-backed securities obligations had climbed to $5.5 trillion.
• Fannie Mae’s conforming loan limit, that is, the maximum loan amount eligible for government purchase or guarantee, is currently $417,000 for a single unit property and as high as $625,500 for a “high-cost area.”
• If the government reduced the conforming loan limit each year until it reached zero, the private mortgage market would have time to adjust and create a robust and competitive market in the securitization of mortgages as Fannie and Freddie left the market.
• The conforming loan limit could be reduced for the largest mortgages first, to maintain the GSE benefit longer for lower-income borrowers whose mortgages do not tend to reach the higher end of the conforming loan limit.
• Despite fears that the end of Fannie Mae and Freddie Mac would signal the end of the fixed-rate mortgage, other mechanisms, such as private-label securitization and covered bonds, have proven capable of funding fixed-rate mortgages, both in the United States and abroad. Private-label securitization is the creation of mortgage-backed securities (MBS) by private markets rather the by GSEs. Covered bonds are similar to securitization in that they gather investor funds to purchase bank-issued mortgages, but the mortgage stays on the bank’s balance sheet.

CONSUMER FINANCE
The unintended consequences of consumer finance regulation often hurt those it’s designed to protect, leaving many consumers with little to no access to credit when they need it most. 

Regulation designed to protect consumers is actually harming consumer choice in three key areas:

Prepaid Cards

• There are as many as 10 million unbanked and 24 million underbanked households in the United States, suggesting a need for alternatives to traditional financial products. A variety of new regulations (including the Durbin Amendment) have contributed to the decline in bank accounts eligible for free checking from 76 percent in 2009 to 39 percent in 2012.
• Demand for prepaid card use implies that this product meets crucial consumer needs. The transaction volume, or the amount of dollars spent, using prepaid cards increased 21.5 percent per year between 2006 and 2009. In 2014, it is estimated that total volume loaded onto reloadable prepaid cards will reach $167 billion, up from $12 billion in 2007.

Overdraft Protection

Regular users of overdraft protection are those who are most likely to be aware of its costs and to choose to use overdraft protection because they believe it to be superior to their available short-term financing alternatives.

• According to a 2009 American Bankers Association survey, a vast majority of those who use overdraft protection are happy that the service is available.
• 96 percent of consumers who paid an overdraft fee acknowledged that they wanted the payment covered.
• At various large banks, 60–80 percent of customers opted-in to debit card overdraft protection, with the median opt-in rate at 75 percent, implying that consumers view overdrafts less as penalties and more as a safety net.

Payday Lending

• Payday lending is an important source of emergency, short-term credit.
• In one survey of payday loan borrowers, 86 percent of respondents “strongly” (70.8 percent) or “somewhat” (15.7 percent) agreed that their loan was to cope with unexpected expenses
• Customers are usually well informed of the costs of consumer finance products.
• Only 2 percent of payday loan customers report that they do not know the finance charge for their most recent loan.

Regulators often forget that short-term credit products like overdraft protection and payday loans are competing products. Limiting consumers’ access to one affects consumers’ use of the other, and careless regulation can force consumers to use products that are more costly or that fail to meet their needs.

THE CONSUMER FINANCIAL PROTECTION BUREAU
With the Dodd–Frank Wall Street Reform and Consumer Protection Act, Congress created the Consumer Financial Protection Bureau (CFPB). The flaws in its structure could lead to increased costs and reduced access to credit for consumers. In addition, the CFPB’s designers chose to set up the agency without any of the most common and effective forms of oversight found in other government agencies. The result is a largely unaccountable new federal bureaucracy with little constraint from any constitutional authority.

• The CFPB’s automatic funding from the Federal Reserve makes the agency largely unaccountable to Congress.
• Because Dodd-Frank instructs courts to defer to the CFPB on its interpretations of federal consumer finance law, the CFPB is largely unaccountable to the judiciary.
• The high bar for removing the single director of the CFPB makes the agency largely unaccountable to the president.
• The CFPB’s research efforts have failed to meet rigorous academic standards. For example, a white paper studying the impact of overdraft programs on consumers makes a number of claims unsupported by the CFPB’s analysis and fails to answer questions it claims to address.
• The CFPB’s data collection efforts are significantly more intrusive than is necessary to achieve its stated goals, and could put the private data of consumers at unnecessary risk. For example, the CFPB’s collection of account-level credit card data on 85–90 percent of outstanding card accounts exceeds the amount necessary to conduct a valid statistical analysis of consumer financial markets, while collecting and maintaining such comprehensive databases of personal financial information places consumer privacy and security at risk.

THE US FINANCIAL SYSTEM
One of the lessons of the financial crisis was the danger of “systemic risk” (risks that could potentially harm the economy and financial system as whole). While this lesson has primarily been used to support more expansive regulatory authority over the financial system, research suggests that many of the underlying causes of the crisis were, at least in part, the result of a mindset that more involvement from central regulators will lead to less risk in the financial system.

Research suggests that not only may regulators fail to solve the problem of systemic risk, they may potentially make the system less safe.

Systemic Risk

• Owing to the complexity of the US financial system, systemic risk cannot be effectively regulated by a centralized regulatory authority.
• Dodd-Frank enshrined “too big to fail” by creating a legal class of institutions known as “Systemically Important Financial Institutions” (SIFIs). SIFIs are those institutions deemed to pose a risk to the broader economy in the event of their failure as determined by the Financial Stability Oversight Council.
• Anticipation of government bailouts of SIFIs or other firms encourages financial institutions to make riskier investments.
• The additional layer of regulation focused on system risk to which SIFIs such as AIG and other firms are now subject could actually increase risk to the financial system as market incentives for managing business practices for safety and soundness are replaced with a focus on regulatory compliance.

Deposit Insurance

• The theory underlying deposit insurance suggests that since it prevents bank runs, the government can provide it at no cost. However, in practice it has real costs; the FDIC expends real resources administering and operating the Deposit Insurance Fund.
• The Deposit Insurance Fund averages $2.67 billion in expenses each year, with a total of $208.33 billion spent since the FDIC opened its doors in 1934 (in 2008 dollars). More than half of those expenses were incurred since 2002.
• Bank capital regulations, specifically risk-based capital regulations, lead to more overall risk in the banking system and may have been the most important causal factor in the financial crisis of 2008, which may have cost the US economy more than $10 trillion.
• Risk-based capital requirements increase systemic risk by encouraging banks to hold the same or similar types of assets that satisfy government standards based on government-set risk-weights, thereby concentrating rather than diversifying risks throughout the financial system.
• The better way to stabilize the financial system is to replace risk-based (risk-weighted) capital requirements with a simple ratio of capital to assets without the risk-weighting, incentivizing firms to assess the actual risk of an asset rather than relying on a predetermined risk assessment assigned by government regulators.

Small and Community Banks

• If additional regulatory restrictions strengthen the trend of small bank consolidation in the United States, many small bank customers may have difficulty meeting their banking needs as banks shutter their doors or are acquired by larger banks whose products and services are not tailored to the community.
• A majority of small banks report that the CFPB has had a “significant negative impact” on their mortgage offerings.
• 82.9 percent of small banks report that their annual compliance costs have increased by more than 5 percent since the passage of Dodd-Frank.

RESPONSIBLE RULEMAKING FOR FEDERAL FINANCIAL REGULATORS
Independent financial regulators face fewer requirements to perform economic analysis than most executive agencies do. As a result of this lax oversight, they fail to perform adequate economic analysis.

• Benefit-cost analysis is just bipartisan common sense, which financial regulators ignore.
• Every president since Ronald Reagan has asked independent agencies to conduct meaningful benefit-cost analysis, yet these agencies routinely choose not to do so.
• In one example, the SEC originally estimated compliance costs for a rule implementing Section 404(b) of Sarbanes-Oxley that required publishing information on internal financial reporting control procedures at approximately $91,000 per publicly traded company. The SEC later revised this estimate to roughly $2.87 million per company.
• Many of the SEC’s regulatory analyses have consistently been of lower quality than those of executive agencies.

Monetary Policy and the Federal Reserve

• Mistakes in monetary policy can have serious consequences. On the one hand, not creating enough money can lead to the kind of massive deflation that turned a severe recession into the Great Depression. On the other hand, creating too much money can result in inflation.
• The Federal Reserve’s current attempts to direct the allocation of credit are overreaching and wasteful, and the Fed should be removed from the formulation and implementation of credit policy.
• The Fed’s role as a “lender of last resort” should apply only to financial institutions that are solvent, but temporarily illiquid—not to banks that are insolvent.