Dodd-Frank in Court

Lawsuit against 2010 financial reform act has first hearing before judge

Chris Dodd, Barney Frank / AP
June 12, 2013

Lawyers representing the State National Bank of Big Springs, 11 states, and two advocacy organizations appeared before a D.C. District Court for the first time on Tuesday, arguing that the Dodd-Frank financial reform act unduly burdens smaller financial institutions and strips states of their legal rights.

The plaintiffs argue that several key parts of the act are unconstitutional, including the Financial Stability Oversight Council (FSOC) and the Consumer Financial Protection Bureau (CFPB). They also argue that President Barack Obama’s recess appointment of Richard Cordray to head the CFPB was unconstitutional.

The plaintiffs and government lawyers sparred in the hearing before Judge Ellen Huvelle over whether the Big Spring bank and the states have actually suffered sufficient injury to come before the court with their suit.

The Big Springs bank argued that it has faced a significant regulatory compliance burden since the law has gone into effect. It also argued that the law places it at a competitive disadvantage with other banks that receive the label of being "systemically important."

The government countered that the claims were premature and "wholly speculative" because many of the regulations have not been completed.

The original private plaintiffs brought their suit in June 2012. Oklahoma, South Carolina, and Michigan joined the lawsuit in September to challenge the Orderly Liquidation Authority, which allows the treasury secretary to break up failing banks and other financial institutions if he thinks they pose a threat to the economy. Eight more states joined the lawsuit in February.

"This is kind of a home run lawsuit on Dodd-Frank, the one that could potentially destroy the whole scheme," said Todd Zywicki, a law professor at George Mason University.

Zywicki highlighted two ways that the bill hurts smaller banks.

The act entrenches so-called "too big to fail" financial institutions by labeling them "systemically important." The label implies these institutions will receive a government bailout if they become insolvent, making them a less risky investment and driving down their capital costs.

The second impact the law has on smaller institutions is increasing the regulatory burden, which impacts smaller banks more than larger ones.

All banks with more than $50 billion in assets are automatically labeled systemically important, and the FSOC can label other nonbank institutions as systemically important as well.

The FSOC voted on June 3 preliminarily to label several nonbank financial institutions systemically important. A Treasury Department spokeswoman said the council will not announce which institutions have received the label until a final decision has been made, although Prudential, AIG, and General Electric Co. were named in news reports as having received the preliminary designation.

"Today, the council took another important step forward by exercising one of its principal authorities to protect taxpayers, reduce risk in the financial system, and promote financial stability," Jack Lew, treasury secretary and chairman of FSOC, said in a statement about the June 3 vote.

Prudential released a statement saying it is considering asking for a hearing to contest the label. A Prudential spokesman declined further comment. A GE spokesman said GE has been prepared for the label, while AIG did not return a request for comment.

The label brings tighter regulations, including higher capital requirements, Prudential said in the statement.

When asked if the regulations would balance out the capital cost advantages, Peter Wallison, an economics expert at the American Enterprise Institute, said, "We don’t actually know the answer to that yet."

"It’s very unlikely that it balances out exactly," Wallison added. Either the regulatory costs will outweigh the benefits, hurting the larger banks, or the benefits will outweigh the regulatory costs, helping them—and both outcomes are bad for the economy, he contended.

This lawsuit could have wide-ranging effect on the financial sector, said Sam Kazman, general counsel at the Competitive Enterprise Institute, one of the advocacy groups suing along with the Big Springs bank.

"CFPB essentially has an incredible amount of power over almost every financial product out there," Kazman said. Their regulations could restrict the types of financial products that banks can offer and drive up costs, he contended.

Wallison argued that the bill has already had a major effect on the economy.

"If the lawsuit is successful, it will be good for the American people and our society because the result will be to knock out many of the provision of Dodd-Frank that I think have caused the very slow recovery that we’ve seen since the Dodd-Frank bill was passed," he said.

The economy was consistently growing before Dodd-Frank passed, but its performance has been weaker following the bill’s passage, Wallison said.

The regulations mandated under Dodd-Frank have been produced at a very slow rate, Wallison noted. An SEC commissioner said in January that the Dodd-Frank regulations were only a third complete.

"There’s never been anything quite this slow, ever," Wallison said. "That in itself is slowing the economy."

Zywicki argued that the bill tightens the link between the banks and policy makers in an unhealthy way.

"The overall impact of Dodd-Frank, if it is allowed to stand, will be to further consolidate the banking industry, to further consolidate the crony capitalistic relationship between Wall Street and Washington, and that would have terrible consequences for consumers," Zywicki said.

"Dodd-Frank is really a pretty disastrous law," he said.