NEW YORK (TheStreet) -- On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act became law. And at the beginning of its fifth year, Dodd-Frank's complete package still hasn't been revealed. Nor have we fully experienced the impact it is going to have on the American economy.
The law is vague and complex at the same time.
It can be argued that good laws deal with process and not outcomes. The resulting Dodd-Frank legislation seems to be more about what legislatures want the banking industry to be rather than how it would like to see the banks function.
Congress probably wants financial institutions that have minimal risk, are consumer friendly, and are generous lenders to families wanting to own their own home and to small- and medium-sized businesses that provide lots of jobs to Main Street.
The result -- Dodd-Frank's 2,300 pages and 398 regulations -- can only be seen as overkill. Congress is trying to mold the banking system. But in my view this kind of legislation does not work.
Look at the environment the banking system has faced over the past 50 years and what it faces going forward. Since the early 1960s, the economic climate in the U.S. has been one of credit inflation. Credit inflation hits not only the prices of the goods and services that are produced and consumed within a relatively short span of time, it also includes the prices of assets like houses, commodities and stocks and bonds.
Since the early sixties, the government of the U.S., whether controlled by Republicans or Democrats, has generally pushed on the credit accelerator. The goal was to keep employment at high levels and to achieve other plans, like increasing home ownership.
This environment produced incentives that resulted in financial institutions making riskier loans, increasing their financial leverage, mismatching the maturities of assets and liabilities, and creating increasingly complex financial innovations. And all of these consequences of credit inflation made the banking system more vulnerable to shocks.
But credit inflation is still the name of the game. And the incentives that go with credit inflation will return.
In order to prevent the financial system from collapsing again, Congress is attempting to legislate a banking system that will be less susceptible to future shocks. In other words, Congress does not want 2008 to happen again.
Dodd-Frank is fighting the last war.
Regulations involve costs. It has been estimated that commercial banks will have to achieve substantial increases in revenue along with much lower costs to get back to a return on equity that meets or exceeds a bank's cost of capital.
In most cases, these costs are more painful for smaller banks to absorb than larger ones. As of March 31, 2014, the FDIC shows that there are 239 fewer commercial banks in the banking system than one year earlier. Of this number, 144 were banks with less than $100 million in assets. The rest held less than $1 billion in assets. In my view, smaller banks just aren't as viable today as they once were.
With all the uncertainty about the regulations and how they will be administered, commercial banks are just not that interested in doing much lending, especially if there are any concerns about a loan.
Another factor favoring the larger banks is the application of information technology. Smaller banks just cannot scale their information technology as well as can larger banks with more resources.
Banks have always been ahead of the regulators in getting around the regulations. But in today's world, with the increasing importance of information technology in the financial industry, the number of ways financial institutions can get around regulations is much greater. (This applies more to the larger banks than to the smaller ones.)
I remember the New Yorker cartoon that shows two bankers talking. One says to the other, "Well, what banking rules do we have to try and get around today?" This certainly was my experience when I worked for the Federal Reserve system.
The result of all this?
As Christopher J. Flowers, private equity investor in financial institutions, was quoted in the Financial Times: "Nobody is going to invest in an industry with returns of 5%."
Unfortunately, return on equity in the banking industry plummeted after the Great Recession. Commercial banks are finding that it is a real struggle to achieve ROE that meets or exceeds their cost of equity, something in the 10% to 12% range.
Move over, here come the shadow banks!
At the time of publication, the author held no positions in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.