Critics of the Dodd-Frank Act have said that it encourages banks to circumvent the rules and many maintain that successful reform, which would encourage the banks to take less risk, was once accomplished in the U.S.
Many banks earn profits based on the spread between rates of return on assets and liabilities, and banks can increase the spread by reducing the interest paid on liabilities like deposits. Banks can also seek out a higher return on the asset side, though the move also involves higher risk, National Review Online reports.
Recent financial reform efforts attempt to limit risky behavior by banks through the implementation of higher capital standards, which proponents maintain will provide cushion against large losses on the asset side. The Volcker Rule ban on proprietary trading is also aimed at reducing risky behaviors by banks by prohibiting investments that do not benefit customers.
While it is in the interest of the bank to maintain higher capital levels, the institutions do not bear all of the risk, meaning they have limited liability in the event of the bank’s failure. Liability holders, such as the depositors, of an institution lose their deposits and shareholders lose their investments, but the banks are not liable, according to National Review Online.
Between the Civil War and Great Depression, however, banks did not have limited liability but instead carried double liability. If a bank went under, shareholders lost their initial investment just as under today’s system, but the receiver would assess the bank’s asset holdings to determine the value of outstanding shares. Shareholders had to pay an amount as much as the current value of shares to compensate creditors and depositors, thereby creating more incentive to carefully examine risk first.
Modern banking reform attempts to identify harmful practices of banks and to implement rules that limit the behavior rather than eliminate the incentives to engage in the behavior. While the practice may be prohibited, the institutions still have incentive to participate in the same practices that led up to the recent financial crisis, National Review Online reports.