Dodd-Frank Is a Pigouvian Regulation.

• Author: Levine, Aaron M.

NOTE CONTENTS INTRODUCTION 1339 I. TWO THEORIES OF 1345 REGULATION A. Command-and-Control Regulations 1346 B. Market-Based Incentives 1348 II. ENDING TOO BIG TO FAIL 1352 A. The Too Big To Fail Problem 1352 B. Dodd-Frank's Command-and-Control Response to Too Big 1355 To Fail C. Critiques of Dodd-Frank's Response to Too Big To Fail 1360 III. DODD-FRANK IS A PIGOUVIAN REGULATION 1363 A. A Pigouvian Theory of Dodd-Frank 1364 B. Methodology 1367 C. The Pigouvian Findings 1369 l. Divesting Commodities Holdings 1370 2. Shedding of SIFI Designation by Nonbank Firms 1381 a. GECC's Response 1383 b. AIG's Response 1390 c. MetLife's Response 1393 d. Prudential's Response 1395 3. Reducing Systemic Risk 1397 IV. THE BENEFITS OF PIGOUVIAN REGULATIONS 1401 A. Regulatory Flexibility 1402 B. Informational Advantages 1405 C. Allocating Responsibility 1406 D. Political Feasibility 1407 V. PIGOUVIAN REGULATIONS 1408 A. Regulatory Arbitrage 1409 B. Black Swan Events 1412 C. Structural Limitations 1413 CONCLUSION 1415 INTRODUCTION

On April 13, 2016, the Federal Deposit Insurance Corporation (FDIC)--the agency tasked with overseeing the liquidation of systemically important financial institutions (SIFIs) during a financial crisis (1)--convened a meeting to discuss Dodd-Frank Wall Street Reform and Consumer Protection Act's (Dodd-Frank) bankruptcy regime. During the meeting, Vice Chair Thomas Hoenig noted that Dodd-Frank had failed to achieve its primary goal of ending the problem of "too big to fail"--the idea that some financial institutions are so important to the broader financial system that the government could never allow them to go bankrupt. Observing that banks are "larger, more complicated, and more interconnected" than they were before the financial crisis of 2007-2008, Hoenig concluded that not a single SIFI had shown that it could "address all phases of a successful bankruptcy if its failure were imminent." (2) On the same day, he issued a statement lamenting that "[t]he goal to end too big to fail and protect the American taxpayer by ending bailouts remains just that: only a goal." (3)

Hoenig's statements reflect the academic and political consensus: scholars and politicians from both sides of the aisle agree that Dodd-Frank has in many ways entrenched--not ended--too big to fail. (4) Although commentators recognize that Dodd-Frank has reduced systemic risk in the financial system, (5) many fear that another financial crisis would still force Congress to choose between bailing out a SIFI or allowing a recession. (6) What is more, some scholars have suggested that Dodd-Frank's regulatory costs have actually compounded the too big to fail problem. Professor Roberta Romano, for example, has argued that Dodd-Frank mandates the adoption of "costly and burdensome regulations, many totally unrelated to the financial crisis, while failing to address key factors widely acknowledged to have contributed to the financial crisis." (7) As a result, she believes that "[Dodd-Frank] has not resolved the 'too-big-to-fail' syndrome. In fact, it could well exacerbate it." (8)

Much of this pessimism rests on the assumption that Dodd-Frank could only solve too big to fail via the measures explicitly included in the text of the statute: namely, through "command-and-control" regulations. (9) In fact, even scholars and policymakers who favor market-based solutions--that is, policy instruments such as taxes that force individuals and firms to account for the social costs of their activities (10)--assume that Dodd-Frank does not currently utilize them. (11) One commentator, for instance, has bemoaned the Act's failure to adopt typical market-based incentives and has urged Congress to improve financial regulation by implementing a tax on bank borrowing. (12) Others recognize that the Act imposes significant costs on bank size, but mistakenly assume that these costs serve no regulatory purpose. (13) Indeed, some commentators even critique these costs as allowing savvy banks to arbitrage away from highly regulated activities and toward tax avoidance strategies that may be just as risky. (14) And other scholars see Dodd-Frank as benefiting certain firms over others, which might exacerbate the too big to fail problem. (15)

This mistake is understandable. The plain text of Dodd-Frank appears either to bar SIFIs from engaging in certain behaviors or to direct SIFIs to follow certain rules and procedures when contemplating specified transactions. (16) As a result, most scholars who have examined Dodd-Frank through a Pigouvian lens tend to assume that, because Dodd-Frank adopts this command-and-control approach, it necessarily rejects market-based incentives, and therefore cannot have a Pigouvian effect. (17)

However, two former members of the Board of Governors of the Federal Reserve have argued that Dodd-Frank's compliance costs--the very costs that are purportedly "unrelated to the financial crisis" (18)--can actually be understood as an economic tool. (19) In two short speeches, former Federal Reserve Chair Ben Bernanke and former Federal Reserve Governor Jeremy Stein observed that Dodd-Frank functions like a Pigouvian tax--that is, a tax that corrects market imperfections by forcing individual actors to bear the costs of the externalities resulting from their actions. (20) Stein, for example, commends Dodd-Frank's "price-based approach" for "creat[ing] some incentive... to shrink" while also "let[ting] [banks] balance this incentive against the scale benefits that they realize by staying big." (21) In other words, even though large financial institutions do not naturally bear the social costs of being systemically important, Bernanke and Stein contend that Dodd-Frank forces banks to internalize some of these costs by making them pay additional compliance costs for being systemically important.

This Note both substantiates and extends Bernanke's and Stein's claims that Dodd-Frank works like a Pigouvian tax. We substantiate their argument by analyzing the SIFI divestitures that have occurred since Congress passed Dodd-Frank in 2010 and by identifying which divestures were motivated--or at least heavily influenced--by compliance costs associated with Dodd-Frank. In this way, we document how Dodd-Frank incentivizes SIFIs to internalize the costs of being systemically important. In addition, we show that these costs have induced SIFIs to shed risky assets and thereby fundamentally change the nature of their operations. Put another way, while Bernanke and Stein have argued that compliance costs serve an economic purpose by allowing regulators to fix market imperfections, this Note argues that those compliance costs can also serve an important regulatory purpose by incentivizing SIFIs to shed the business units that generate financial risk in the first place. Because of these regulatory effects, we call Dodd-Frank a "Pigouvian regulation." (22)

Viewing Dodd-Frank as a Pigouvian regulation has several important consequences. First, it reveals Dodd-Frank's novel and effective regulatory model. Scholars may be correct that firms remain too big to fail, but by creating incentives for SIFIs to shed risky assets, Dodd-Frank provides a blueprint for addressing systemic risk without requiring regulators to formally break up large financial institutions or to establish a viable bankruptcy regime. Instead, Dodd-Frank gives SIFIs a simple choice: either pay the hefty SIFI compliance costs or shed risky business lines and, in doing so, reduce the chance that their failure will trigger an economic crisis.

Furthermore, because regulators can tailor Dodd-Frank's compliance costs to the perceived riskiness of certain financial activities, they can target the most systemically destabilizing business units and can adjust those costs as market conditions change. This flexibility has three informational advantages over alternative regulatory frameworks. First, regulators can tailor the costs to the unique risks posed by different financial institutions. Second, regulators can adjust costs over time as they acquire additional information and as market conditions change. And third, Pigouvian regulations take advantage of relative institutional expertise. Traditional command-and-control regulations require regulators to calculate both the costs and benefits when determining the socially optimal level of a risky activity. By contrast, under Dodd-Frank, regulators simply determine the social costs of being systematically important and allow financial institutions--which better understand the value of being large and engaging in certain transactions--to determine the benefits.

This Note proceeds in five Parts. Part I presents two current regulatory paradigms --command-and-control regulations and market-based incentives--as context before situating Pigouvian regulations between these two theories. Part II briefly explains how Dodd-Frank sought to end too big to fail and describes the current view of Dodd-Frank as a command-and-control response to the problem of too big to fail and the criticisms of the command-and-control approach. Part III presents our theory of Dodd-Frank as a Pigouvian regulation and our empirical findings that document how the Act has prompted firms to divest risky assets. Part IV considers the benefits of the Pigouvian approach and explains why regulating too big to fail in this way is preferable to other options generally discussed by scholars and politicians. Part V concludes with a discussion of potential downsides and prescriptive recommendations for how to make Dodd-Frank a more effective Pigouvian regulation.

1. TWO THEORIES OF REGULATION

   This Part describes the two primary regulatory approaches--command-and-control regulations and market-based incentives--before explaining in the remainder of the Note how Dodd-Frank fits between these two approaches.

   1. Command-and-Control Regulations

      In a command-and-control regulatory scheme, the...