Yellen Is Wrong About Financial Regulation

On the other hand, most policymakers inside the beltway view this regulatory framework as sacred. They’re happy to talk about it, but only if you want to expand it.

I’m positive, though, that only a select few members of Congress know many of the details. And if the rest did spend the time to dig in, they would recognize three things: There was no substantive deregulation of financial markets in the last century; regulating to safeguard financial stability was not invented after the 2008 financial crisis; and much of the theory behind the post-2008 regime is little more than wishful thinking.

For those interested, there is a great debate here.

On the establishment side, we have folks like Treasury Secretary Janet Yellen. Even though she claims to have “focused on financial stability” throughout her career, she believes it was productive to enact “new macroprudential policies focused on mitigating systemic risk” in the wake of the 2008 financial crisis.

She argues that these regulations have “strengthened the financial system,” but she offers no direct evidence. (Yes, many banks have higher capital now versus 2007, but that could have been achieved without passing any new laws, much less the 2010 Dodd-Frank Act.) And if those new regulations worked so well, it stands to reason Yellen should not have had to bail out uninsured depositors in three banks that failed in 2023. If that bailout was necessary to save the world from financial catastrophe, those regulations could not have work as advertised.

Yellen also believes in Dodd-Frank’s Financial Stability Oversight Council.

For those lucky enough to be unaware, the FSOC is the multi-regulator council that is supposed to reduce future government bailouts by, among other things, identifying threats to financial stability. As hard as it is to believe, Congress decided that even though the United States already had more than 10 financial regulators who failed to even see a financial crisis coming, a good solution was to give those regulators even more responsibility.

Yellen recently argued that the FSOC was necessary to give regulators “a more holistic view of and approach to risks.” Again, the idea that nobody was regulating systemic risk prior to the creation of FSOC, in a holistic way or any other way, is undeniably false.

Regardless, here’s the kind of riveting risk analysis the FSOC produces. It’s 2019 annual report stated that “Firms with high levels of debt may be vulnerable to unexpected financial or economic events that may negatively affect their repayment and refinancing capacity.” Who knew?

And in 2022, with Yellen as Treasury Secretary, the FSOC warned that the commercial real estate market “faces a more uncertain outlook given elevated inflation, rising interest rates, a slowing economy, and the potential for structural changes in behaviors due to the COVID-19 pandemic.”

If it really is too much to expect the folks at the Fed and the FDIC to know about this uncertain outlook, Congress has all the evidence it needs to restructure the regulatory framework.

I’m much more aligned with my colleague, Mark Calabria, former director of the Federal Housing Finance Agency and former FSOC member. In his retrospective 2023 book, Calabria wrote “This may be the FSOC’s real strength, pointing out problems in our financial system for which none of its members bear any authority or responsibility.”

Although I do think the FSOC has been rather useless, I am still highly critical of the theory behind its creation. The last way to prevent large bailouts, for instance, is to have federal regulators pre-identify those firms they believe pose excessive systemic risk.

But that’s what the FSOC is supposed to do.

The theory behind the FSOC is that regulators can impose regulations to prevent financial crises. But we already know that premise is false. Worse, we know that government policies tend to be a main contributing factor in virtually all such events throughout history.

That’s all bad enough, but if we accept the theory behind the FSOC arrangement, we cannot possibly accept the theory behind the superiority of the free enterprise system.

It may not be so obvious, but the truth is that, if a massive bank were to fail, it would present no greater danger to people’s ability to earn a living than the failure of a company like Walmart, Ford, or Home Depot. In each case, we’re talking about millions of people’s money and their ability to earn more of it.

If we accept the notion that financial firms cannot exist without heavy-handed regulation to prevent calamity, then we must also accept the same for nonfinancial companies.

More broadly, federal regulators should not be empowered to stop people from engaging in financial or economic activities the regulators believe are too risky. As I’ve argued for years, the mere existence of the FSOC is wholly incompatible with the functioning of a dynamic private capital market. Congress should eliminate it, reduce invasive federal regulation, and stop giving bureaucrats the power to micromanage financial risks.