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Examining the Belief That Modern Financial Regulations Restrain the U.S Economy

Updated on June 8, 2017

Issues with Modern Financial Regulations

It is being debated whether Sarbanes-Oxley and other similar regulations are giving foreign markets an edge over the US economy. So let's take an academic approach to understanding the reasons why financial regulations are enacted, their effect on the economy, and their measure of efficacy.

This article considers the scope of the problems that caused such policies to be enacted and after enactment identifies what performance measures are used to validate why the policies remain in place. This piece also provides an outlook of what the U.S financial system could possibly look like without these regulations.

Are U.S. Markets Losing Their Edge?

According to Mishkin (2015), in the past few decades, several countries surpassed the U.S. in industries where the United States had previously demonstrated prowess and superiority. The United States was the leader in the manufacturing of automobiles and consumer electronics, now other countries hold the competitive advantage in these areas and many worry that the dominance the U.S has in the financial markets is slipping away. There are several indicators that the United States is not the leader it once was. For example, the London and Hong Kong stock exchanges presently house a greater share of initial public offerings (IPOs) than the New York Stock exchange which before the year 2000 held the title of the most dominant exchange in terms of IPO value (Mishkin, 2015). This does call for a bit of concern but the analyst must be cautioned about taking this data out of context and attributing blame incorrectly.

These arguments must pay attention to the fact that developing and emerging markets will over time gain a more formal structure, therefore, it is to be expected that firms in these growing markets will seek the most natural avenue for financing. U.S markets require a higher level of integrity from firms and this is a good thing since firms that are less prone to moral hazard are more likely to appropriately handle risk. Properly regulated firms are less likely to fail hence these firms create a stable market. At present stability might be a greater priority than fast growth as it was seen in the 2007-2008 Financial Crisis growth due to uncharacteristic behavior can easily be wiped out.

Berkshire Hathaway’s CEO Warren Buffet is one of the most respected voice on the economy and here is what he had to say when fortune magazine asked if he thought the U.S. financial markets are losing their competitive edge due to regulation?

Warren, straight away expressed that he did not think so. He explained that even though there is a cost associated with regulations such as Sarbanes-Oxley, the cost is minimal relative to the $20 trillion total market value these regulations are set up to protect. Regulations are necessary to protect the markets from systemic risk but he stated that “There are significant limits to what regulation can accomplish” (Varchaver, 2008). He provided an insightful example of such limitation in the Office of Federal Housing Enterprise Oversight (OFHEO) whose 200 employees were tasked with monitoring two companies namely, Freddie Mac, and Fannie Mae yet the OFHEO failed to spot billions and billions of dollars in accounting misstatements that could have had a dire effect on the economy. This illustration shows that the efficacy of regulation is really difficult to measure but Warren again gives another illustration to the same source that demonstrates the importance of regulations. It was regulations in place that allowed the Fed to take over Bear Sterns. Due to that company’s overexposure to risk contracts of 14 trillion notational value were in jeopardy of being liquidated. The Fed intervention spared the financial markets from this catastrophic event thus proving a perfect example of exactly how meaningful regulation can be to the overall market (Varchaver, 2008).

The value of regulation to the financial markets is well established but there are consistent complaints that particular regulations are costly, ineffective and sometimes redundant to the point that it stifles business. Turning to Donald Trump to understand the depth of concerns about the negative effects of what he like others of like minds believe to be over regulation are reasons that don’t seem to be aligned with the populist ideals of standing up for the little guy. Actually, Trump and other conservative opposition to Dodd-Frank leave much to the imagination when asked why this particular regulation is so offensive or onerous. Trump the “King of Debt” told Reuters in an exclusive interview during his 2016 bid for President that he would demolish the Dodd-Frank act, as to his reason he stated, “Dodd-Frank is a very negative force, which has developed a very bad name.” (Reuters, 2016).

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, wrote in the Wall Street Journal three possible reasons why Trump takes a hard line stance against Dodd-Frank is that he is simply regurgitating republican orthodoxy that regulation is bad for business. The second reason is that Trump is tightening his relationship with big money interest to back his political campaign. The third reason Mr. Blinder offers is rather cynical but not entirely impossible he believes Mr. Trump has taken a barely thought-out position against the regulation because he does understand what Dodd-Frank entails (Blinder, 2016). Ignorance of why policies are formed as well as the protection accomplished by the various laws might explain some of the misguided opposition to these regulations.

Why are Policies Formed?

New policies are usually enacted as a reaction to a behavior or an event that requires attention in order to deter or prevent the same actions or incidents from being repeated. Modern regulations like Sarbanes-Oxley and Dodd-Frank were put in place as tools with which to curtail moral hazard and agency problems.

Financial Institutions Are Susceptible to Moral Hazard

Wells Fargo in 2016 became embroiled in a scandal over bank employees opening accounts without customers’ authorization.
Wells Fargo in 2016 became embroiled in a scandal over bank employees opening accounts without customers’ authorization.

Sarbanes-Oxley

The Enron Scandal that rocked Wall Street shed light on the duplicitous behavior that can emerge and overrun even the largest most successful companies. These large companies have the ability to greatly affect the economy. According to Mishkin (2015), Enron was valued at $77 billion just one year before disclosing that the company had racked up a $618 million loss in just the third quarter due to so-called accounting mistakes. This prompted further investigation by the SEC. The results of the SEC investigation revealed that the company’s misdealing was not accidental.

Enron through a complex scheme led by its former financial chief concealed substantial debt and financing arrangements, therefore, making the company balance sheet seem impeccable. The company collapsed at the ending of 2001 despite securing $1.5 billion of new money from two of the country’s largest banks. Mishkin (2015) states that Enron was the seventh largest company in the United States and up to that point was the largest bankruptcy in U.S. history. This scandal demonstrates the importance of government regulation in lessening asymmetric information. The scandal also provides the prelude of why Sarbanes-Oxley Act was introduced.

According to Mishkin (2015), Sarbanes-Oxley created the Public Company Accounting Oversight Board (PCAOB) which is run by the SEC. The PCAOB is tasked with ensuring the highest level of transparency in accounting audits and that the firms conducting these audits are independent. Sarbanes-Oxley also reduces conflicts of interest by making it illegal for a public accounting firm to accept further work in lieu of providing an accounting audit. This removes any incentive for the accounting firm to conceal an impermissible activity in order to support an existing client. Sarbanes-Oxley also increased the penalties associated with white-collar crimes and increased the quality of information by making the CEO, and CFO, as well as auditors, responsible for certifying financial statements.


Despite regulation, like Sarbanes-Oxley companies will still do foolish things but that should in no way imply that regulations are not effective. Complete elimination of asymmetric information, moral hazard and agency problems is just not a realist measure of effectiveness or efficacy of any single regulation. There are several examples of spectacularly successful companies that got caught up in the duplicitous behavior of one form or another even after the enactment of Sarbanes-Oxley. Some recent big company misdealings have included companies such as AIG, Sallie Mae Volkswagen, Wells Fargo and others, the conclusion of this is that policies must continue to evolve as companies exploit different ways of cheating the system. Unfortunately, innovation in the case of policy-making usually trails the innovations of the crime.

The Enron Scandal that rocked Wall Street shed light on the duplicitous behavior that can emerge and overrun even the largest most successful companies. These large companies have the ability to greatly affect the economy. According to Mishkin (2015), Enron was valued at $77 billion just one year before disclosing that the company had racked up a $618 million loss in just the third quarter due to so-called accounting mistakes. This prompted further investigation by the SEC. The results of the SEC investigation revealed that the company’s misdealing was not accidental.

Enron through a complex scheme led by its former financial chief concealed substantial debt and financing arrangements, therefore, making the company balance sheet seem impeccable. The company collapsed at the ending of 2001 despite securing $1.5 billion of new money from two of the country’s largest banks. Mishkin (2015) states that Enron was the seventh largest company in the United States and up to that point was the largest bankruptcy in U.S. history. This scandal demonstrates the importance of government regulation in lessening asymmetric information. The scandal also provides the prelude of why Sarbanes-Oxley Act was introduced.

According to Mishkin (2015), Sarbanes-Oxley created the Public Company Accounting Oversight Board (PCAOB) which is run by the SEC. The PCAOB is tasked with ensuring the highest level of transparency in accounting audits and that the firms conducting these audits are independent. Sarbanes-Oxley also reduces conflicts of interest by making it illegal for a public accounting firm to accept further work in lieu of providing an accounting audit. This removes any incentive for the accounting firm to conceal an impermissible activity in order to support an existing client. Sarbanes-Oxley also increased the penalties associated with white-collar crimes and increased the quality of information by making the CEO, and CFO, as well as auditors, responsible for certifying financial statements.

Despite regulation, like Sarbanes-Oxley companies will still do foolish things but that should in no way imply that regulations are not effective. Complete elimination of asymmetric information, moral hazard and agency problems is just not a realist measure of effectiveness or efficacy of any single regulation. There are several examples of spectacularly successful companies that got caught up in duplicitous behavior of one form or another even after the enactment of Sarbanes-Oxley. Some recent big company misdealings have included companies such as AIG, Sallie Mae Volkswagen, Wells Fargo and others, the conclusion of this is that policies must continue to evolve as companies exploit different ways of cheating the system. Unfortunately, innovation in the case of policy-making usually trails the innovations of the crime.

Financial Regulations Help Keep Wall Street in Check

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Do you believe financial and consumer protection regulations like Dodd-Frank are starving U.S. companies of resources allowing foreign economies to gain an advantage?

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Dodd-Frank Act

Following the Great Recession of 2007-2008, there was a massive public outcry that the too- big-to-fail (TBTF) concept among financial institutions was among the more serious of conditions that contributed to the economic downturn and an expensive government bailout. Why should big banks be rewarded with bailouts after their costly mismanagement and deceit? This question was at the forefront of public concern during and after the recession. According to the St. Louis Fed “Treating a bank as TBTF extends unlimited protection to all of the bank's creditors, not just depositors, which gives the big banks a funding advantage and more incentive to take on greater risk than other banks (Wheelock & Lopez, 2012).” Congress moved to eliminate the too-big-to-fail concept by enacting Dodd-Frank in 2010. Dodd-Frank introduced a new set of rules that gave the government broad oversight over banks and other financial institution’s to deter over exposure to risk (Wheelock & Lopez, 2012).

According to Blinder (2016), Congress successfully eliminated TBTF with Title II of Dodd-Frank which gives the Fed the authority to take over banks and organize the liquidation of their assets, the Dodd-Frank Act removes the option of a bailout or life support. Blinder (2012) contends that banks may still be too big, but not too big to fail. However many experts including Mishkin (2015) concede that the only definitive way to avoid the moral hazard of TBTF is to reintroduce the Glass-Steagall Act. However, the St. Louis Fed argues that breaking up big banks also has a major cost associated with doing so because it prevents economy of scale and other efficiencies of service that comes through the operation of big banks (Wheelock & Lopez, 2012). On the other hand Paul Kupiec of the Hill believes that Dodd-Frank gives advantage to big banks by citing data from a 3 year before and after analysis which showed smaller banks had lower funding cost in the years prior to Dodd-Frank but since its inception big banks have enjoyed a substantially lower average funding cost (Kupiec, 2014). Therefore the debate continues that the Dodd-Frank Act is inadequate and still costly.

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Should the Glass-Steagall Act be Re-Enacted?

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The Glass-Steagall Act of 1933

This piece of regulation created the FDIC to protect depositors, and to eliminate moral hazard by focusing on the separation of commercial banking from the securities industry. According to Mishkin (2015), the Glass-Stegall Act is a method of eliminating TBTF by separating financial institutions whose failure could bring down the system. This separation means regulators wouldn’t have the need to bail them out and thereby subject them to market forces. The Glass-Stegall Act was repealed in the year 1999 to increase competition but the erosion started long before then with banks finding innovative ways to exploit loopholes in the law. A loophole noticed in the late 1980’s allowed bank holding companies to underwrite securities including real estate and stocks. This avoidance of regulation makes the effectiveness of the law questionable.

Overhauling the system to accommodate the reintroduction of the Glass-Stegall Act is a costly proposition. Why repeal Dodd-Frank when there have not been any incidents to show that it does not work? There is actually evidence to the contrary, the Boston Globe reported in January 2014 that several companies including MetLife, GE, and Citigroup after being designated systematically important by regulators chose to reduce their footprint with no harm to their profitability. We need big banks for the many reasons they benefit the economy and Dodd-Frank regardless of its limitation continues to demonstrate that it works to allow the current system to be rigorously monitored for moral hazard. The cost of regulation is minimal in comparison to the assets being protected and should be acceptable as long the largest financial market in the world remains solid.

The Cost of Regulation vs Moral Hazard

According to the Wall Street Journal, the six largest U.S. Banks have paid a combined $70.2 billion to comply with laws originating after the financial crisis of 2007-2009 (Chaudhuri, 2014). This figure seems pricey until the cost of not having adequate regulation is taken into consideration. According to Mishkin (2015), the taxpayer-funded bailout known as the Emergency Economic Stabilization Act authorized a $700 billion relief to financial institutions. This comparison proves that regulation successfully reduces the fiscal cost of rescuing banks. According to Mishkin (2015) each time the U.S. has bailed out the banks it has cost about 4% of the country’s GDP. The toll on other countries where regulation is relaxed is significantly greater and has had a crippling effect on their economy. Argentina, Iceland, and Jamaica all gave up 44% of their GDP to rescue banks (Mishkin, 2015).

The cost of regulation is truly minimal in comparison to the benefit and the value of the assets these regulations protect from overexposure to risk. According to the St. Louis Fed the five largest U.S. Banks accounted for 48% of the total system assets, four of which each had assets in excess of a trillion dollars, J.P. Morgan Chase had $1.8 trillion or 14% of total commercial banking assets (Wheelock & Lopez, 2012). America has led the way in sensible consumer and market protection laws and the rest of world is starting to acknowledge the benefits of stricter regulation. According to Global Finance Magazine what started as a U.S. centric trend to increase regulation is spreading rapidly to other countries. Great Britain’s Bribery Act went into effect in 2011, and more recently South Africa, Canada, India, Brazil, and Mexico have all enact new far-reaching legislation to combat fraud, money laundering, other moral hazards and asymmetric information (Pasquali, 2015).

Solving the Problem of Fleeing Companies

Graham Bowley of the New Times wrote that while big companies and popular companies like Groupon and Linkedin have no problems listing on the U.S. stock exchanges he highlights in a piece entitled ‘Fleeing to Foreign Shores,’ that small companies without established profitability find it easier to make IPO in foreign capital markets like Taiwan (Bowley, 2011). Regulations like Sarbanes-Oxley and Dodd-Frank intimidate shaky companies and in so doing helps the capital markets avoid adverse selection. These regulations provide a solution to a problem that’s why they were installed in the first place pulling them will only cause those issues to return. The problems for which regulations are blamed can almost certainly be more appropriately attributed to the high U.S. corporate tax rate. Fix the corporate tax rate and the arguments and concerns raised in this paper about the effects of regulation on the competitiveness of the markets will dissipate.

The corporate tax rate is the problem that causes corporate tax inversion. Fix this problem and the big American companies sheltering assets overseas will bring that money back to invest in these small unproven but innovative startups that would otherwise seek to fund themselves offshore. The Economist explains that if it wasn’t for the threat of consumer boycotts and bad publicity very few companies would remain based in the United States considering its corporate tax rates reach up to 39% in comparison to places like Ireland where the corporate tax rate is 12.5% ( Economist.com, 2015). According to Investopedia Apple shelters $180 billion of its total cash holdings abroad by establishing domicile in Ireland where it avoids U.S. tax rates more significantly Apple has shifted its R&D to that country for additional tax benefits (Nath, 2015). Imagine what those high-paying R&D jobs could do for the U.S. economy not to mention the $180 billion in cash which would certainly be used to invest in the money market and the acquisition small startups. The problem of companies setting up domicile, investing in and raising funds in other country begins with the high U.S. tax rate and ends when it is meaningfully reduced.

According to Investopedia, the largest U.S. companies have approximately $2 trillion in profits that remain tax sheltered offshore. This amount is roughly a tenth of the financial markets total value. The advances in technology and globalization actually require the United States to adapt regulation at a faster pace in order to stay ahead of competitors and to prevent more companies from being lured overseas. For example, several countries are going cashless and digital currencies such as bitcoin is perforating the system, the world atlas website ranks the U.S. number 8 in cashless transactions behind 7 of the top countries known for being tax havens to U.S. companies (Nag, 2016). The U.S. must develop swift regulation to deal with the transition to a digital and cashless global economy or be prepared to lose more companies and their cash to overseas markets.

Consider the cost-savings if a country were to avoid phone network infrastructure skip that stage altogether and leap forward to wireless and fiber optics. This is the imagery of where the United States is positioned in the world today and there is a risk that our financial markets will end up stuck in the savage age of dial-up while other financial markets leap forward with fiber optic speeds. The point is regulation is needed to protect our competitive edge, therefore, regulators must adapt as swiftly as technology and the global economy advances. U.S. corporate tax rate needs to come way down to get cash flowing back into this country and new regulation needs to be in place to handle the transition to a cashless society before more of America’s wealth ends up overseas in more advanced financial markets.

In The Author's Opinion Our Economy Needs Regulations

The value of strict regulation cannot be omitted especially in an economy that is heavily dependent on big banks which are prone to moral hazard. Small banks made competition surprisingly stagnant and that’s why the Glass-Steagall Act was ultimately repealed (Mishkin, 2015). Therefore it is arguable that it is the big banks that give the United States its competitive edge as the largest, most prosperous economy. But, there is a real threat that any of these giant banks can become infected with moral hazard and topple the entire system. If the U.S. is to continue depending on big banks, the economy must be protected by comprehensive regulation that will continuously weed out asymmetric information, prevent adverse selection, and deter moral hazard. Regulation can be thought of as insurance protection policies therefore as the value of the asset increases the cost of regulation increases proportionally. Hence, it is appropriate and reasonable to expect the largest economy to have the highest protection cost. The value of having regulators protect the financial markets is well worth the price.

References

Blinder, A. S. (June 07, 2016). Why Trump, the ‘King of Debt,’ Hates Dodd-Frank. Wall Street Journal - Online Edition.

Bowley, G. (June 08, 2011). Fleeing to Foreign Shores. New York Times, 160, 55430.)

Chaudhuri, S. (2014). The Cost of New Banking Regulation: $70.2 Billion. WSJ.

(2015). Economist.com. Retrieved 24 MAY 2017, from http://www.economist.com/blogs/economist-explains/2015/08/economist-explains-9

Exclusive: Trump would talk to North Korea's Kim, wants to renegotiate climate accord. (2016). Reuters.

Kupiec, P. H. (January 01, 2014). Dodd-Frank doesn't end 'too big to fail'.(COMMENT). The Hill, 21, 89.)

Mishkin, F. S., & Eakins, S. G. (2015). Financial markets and institutions. Pearson Education New York.

Nag. (2016). Top Countries Using Digital Money For Cashless Transactions. WorldAtlas.

Nath, T. (2015). Inversions and Transfer Pricing Will Hurt the US Economy. Investopedia.

Opponents dislike Dodd-Frank because it works - The Boston Globe. (2016). BostonGlobe.com.

Pasquali, V. (May 04, 2015). COMPLIANCE GOES GLOBAL: THE UNAVOIDABLE COSTS OF INCREASING REGULATION. Global Finance Magazine.

Varchaver, N. (April 28, 2008). What Warren thinks. Fortune, 157, 8.)

Wheelock, D. C., & Lopez, D. (October 01, 2012). Too Big To Fail: The Pros and Cons of Breaking Up Big Banks. Regional Economist, 20, 4.)

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    • lions44 profile image

      CJ Kelly 2 months ago from Auburn, WA

      Angelo, nice work. I deal w/these regulations every day. They do protect the economy, not hurt it. They also force increased scrutiny on financial institutions (banks, credit unions, investment houses, etc.). Businesses stay "clean" when the light is shining on them.

      Every year, both federal and state regulators examine the institution. Reporting requirements have also increased and it forces honest assessments. CFOs and CLOs have to think twice because of the severe penalties. I used to feel the same as my fellow conservatives. But being on the inside and seeing what can happen, changes your perspective.

      Will it stop all white collar crime and corporate greed? No. But every little bit helps.