http://mercatus.org/sites/default/files/publication/dodd-frank-FINAL.pdfDodd-Frank : What It Does and Why It’s Flawed
Mercatus Center, George Mason University
Introduction:
It has been more than five years since the financial crisis began
and more than two years since the passage of the legislative
response, the Dodd-Frank Wall Street Reform and Consumer
Protection Act ( Dodd-Frank ).1 The nature and magnitude of the
effects of the largest piece of financial legislation in generations will
become clearer as regulators exercise the broad discretion given
them under the act. Regulators’ efforts at implementation are far
from complete, with many of the rules still unwritten and others
not yet in effect. Regardless of how the rules are written, the act will
certainly have far-reaching effects on the financial system and our
economy. This book takes the opportunity to look at Dodd-Frank as
it is being implemented and asks whether it is an effective response
to the financial crisis that so deeply rattled our nation.
As is typical of crisis legislation, Dodd-Frank included many provisions
crafted in haste and many other provisions drafted before the crisis
for which the act provided a convenient legislative vehicle. Even as
the law was being passed, its proponents acknowledged its imperfections.
2 In the years since the law’s passage, the fundamental flaws with
the legislation have become more evident.3 Dodd-Frank not only failed
effectively and holistically to respond to the crisis, but it also gives rise
to a whole new set of problems that could overshadow the act’s good
elements and lay the groundwork for a future financial crisis.
Many of the provisions in Dodd-Frank are entirely unrelated to
the crisis. Title IV, which requires hedge-fund registration, and Title
XV, which imposes a number of miscellaneous disclosure provisions
on public companies, illustrate this phenomenon. Another example
is the “Durbin amendment” in Title X, which sets price controls on
fees banks can charge merchants in connection with debit cards.
Other provisions, while purportedly solutions to real problems
that emerged in the crisis, could serve to exacerbate those problems.
As one example, Lawrence J. White explains in his essay in
part II how Title IX’s regulatory regime for credit rating agencies will
decrease competition and thus solidify the market share of the largest
credit rating agencies.
The most striking omission of the act was its failure even to
attempt to reform the broken housing-finance system in the United
States. The legislation ignored Fannie Mae and Freddie Mac, the
flawed government-sponsored mortgage giants at the heart of the
housing crisis. White explains the gravity of this omission and Congress’s
continuing failure to act with respect to housing-finance
reform. The failure to act is not for want of workable solutions,4 but
is a result of the interest special-interest groups have in maintaining
the status quo.
Dodd-Frank’s proponents portray it as a solution to the too-bigto-
fail problem that led to the massive bailouts during the financial
crisis. A closer look at Dodd-Frank suggests that it not only failed
to solve the too-big-to fail problem, but it also institutionalized the
problem. One of Dodd-Frank’s new bureaucracies, the Financial Stability
Oversight Council ( FSOC ), has new power to designate firms
“systemically important,” a phrase even experts on macroprudential
regulation have trouble defining in an agreed-upon way.5 White
points out that these designated firms will receive special regulatory
treatment. As the Title I section describes, the additional regulatory
burden will be accompanied by an unspoken commitment that
regulators will step in to save designated firms and their creditors if
there is trouble. This implicit government guarantee carries a perverse
incentive for large firms to take on more risk and a decreased
incentive for large firms’ shareholders and counterparties to penalize
them for doing so.
Also contributing to the institutionalization of too-big-to-fail
is the concentration of risk that emerges from Dodd-Frank. As the
Title VII section discusses, derivatives clearinghouses after Dodd-
Frank will form a new set of large, interconnected, critically important
financial entities. Likewise, the government’s involvement in
the mortgage market has grown after the financial crisis, and Dodd-
Frank’s securitization reforms solidify the continued dominance of
taxpayer-supported housing finance.
The companion of Dodd-Frank’s entrenchment of big financial
companies is its adverse effect on small ones. With its numerous and
incomprehensible complexities, Dodd-Frank gives big banks a competitive
edge over their smaller rivals, who are less able to hire the
lawyers and compliance personnel necessary to advise on complying
with the law in the most cost-effective manner. The effects on small
banks may be one of the most profound unintended consequences of
a law designed to rein in big banks, but only time will tell.
Dodd-Frank creates a regulatory system that suppresses market
discipline in favor of regulatory expertise and broad regulatory authority.
Congress left key decisions to regulators; it afforded them tremendous
discretion to define the limits of their own authority and places
unrealistic expectations upon them.6 The underlying assumption that
regulators can effectively micromanage the market is flawed.7 Giving
regulators more levers to pull and buttons to push with respect to the
financial system only creates a false sense of security.
The irony of expanding the role of regulators in the aftermath of
a financial crisis in which regulators were complicit is heightened by
the fact that even failed regulators were given new powers. With the
exception of the Office of Thrift Supervision, which was eliminated,
regulators were not held accountable for regulatory failures but were
rewarded with new powers. The sections on Titles I, VIII, and IX, for
example, discuss some of the new powers given to the Securities and
Exchange Commission ( SEC ) and to the Federal Reserve ( Fed ), both
of which failed quite dramatically in their oversight roles the last
time around. In the case of the Fed, as the Title XI section details,
Dodd-Frank introduced some new transparency and accountability
mechanisms for its future bailout programs. Nevertheless, questions
remain about the adequacy of these reforms.
To make matters worse, Dodd-Frank gives some of these regulators
a free hand, with few meaningful accountability checks, to intervene
in the economy as they please. For example, Title II authorizes
the Federal Deposit Insurance Corporation ( FDIC ) to take over and
liquidate companies, and Title X creates the remarkably unaccountable
Consumer Financial Protection Bureau ( CFPB ) within the Fed.
The CFPB is one of the powerful new bureaucracies created by
Dodd-Frank. The FSOC and the Office of Financial Research ( OFR )
are two other new Dodd-Frank agencies. As the sections on Titles
I and X discuss, these agencies are shielded from accountability to
Congress, the president, and the American people.
So much of the decision making was left to regulators that the full
implications of the law may not be known for years. The implementation
process is not keeping pace with statutory requirements, and
many deadlines have been missed.8 Implementing the vague concepts
laid out in Dodd-Frank is not an easy task, as the Volcker Rule
discussion in White’s essay and the Title VI section illustrate. Most
Dodd-Frank rules are being crafted without the benefit of thorough
economic analysis.9 The rulemaking gaps and absence of economic
analysis mean market participants and regulators remain uncertain
about how Dodd-Frank will work in practice. As one example, regulators
only recently defined a derivative, though that definition is
central to all of the derivatives reforms in Title VII of the act.
Adverse consequences for consumers are already coming to light.
As is often the case, measures intended to protect consumers can end
up harming them. Given Dodd-Frank’s breadth, these consequences
range from possible threats to privacy, as discussed in the Title I section,
to decreased consumer choice and increased consumer costs,
as discussed in the Title X and XIV sections. The Title XIV section
provides an example of a troubling trend in regulatory policy—the
idea that government knows better than consumers what is best for
them. Government officials have taken on the paternalistic role of
safely steering citizens toward “better” or “safer” products and services.
As a consequence, consumers increasingly will face a one-sizefits-
all market that costs more and offers fewer choices.
Another less obvious ramification of Dodd-Frank is that it distracts
regulators from their core missions. The Title IV section discusses
this phenomenon in the context of the SEC’s new hedge-fund
authorities. Likewise, the Commodity Futures Trading Commission
( CFTC ), newly preoccupied with regulating systemic risk,11 has
found it difficult to devote adequate time to handling the recent failures
of two CFTC-regulated firms that resulted in substantial retail
customer losses.
Many of the consequences of Dodd-Frank remain to be seen,
but as McLaughlin and Greene demonstrate in their essay in Part II,
Dodd-Frank already has had a measurable effect. Using the content
of the regulatory text itself as a data source, they quantify the number
of new restrictions generated by Dodd-Frank rules in 2010 and 2011.
If the new Dodd-Frank rules create restrictions at the same rate, the
authors estimate that Dodd-Frank will cause a 26 percent increase in
the number of restrictions in the financial market regulation titles of
the Code of Federal Regulations.
Often it is suggested that although Dodd-Frank has its problems,
no other solutions were being proposed at the time. As J. W.
Verret demonstrates in his essay in part II, there were other ideas
for remaking the financial regulatory system. Verret discusses then–
Treasury Secretary Henry Paulson’s blueprint for financial reform,
which came out in early 2008. Although that plan also had weaknesses,
some of the suggested reforms proved prescient, such as recommended
mortgage-market reforms. The blueprint recommended
merging the CFTC and the SEC, agencies with considerable regulatory
overlap. Dodd-Frank not only fails to implement this idea, but,
as the Title VII section illustrates, it also gives the agencies redundant
rule-writing tasks related to derivatives. Verret shows that although
the Paulson plan was not perfect, its existence demonstrates that
alternative paths for financial reform could have been considered.
This book is not intended to provide a comprehensive summary
of Dodd-Frank, but rather it seeks to offer a closer look at some of its
provisions in an effort to seriously assess its efficacy. Looking behind
the act’s celebrated objectives shows that it not only fails to achieve
many of its stated goals, but it also reinforces dangerous regulatory
pathologies that became evident during the last crisis and creates
new pathologies that could lay the groundwork for the next crisis.
Wine is sunlight, held together by water - Galileo Galilei
Un jour sans vin est comme un jour sans soleil - Louis Pasteur
Water separates the people of the world; wine unites them - anonymous
Wine is the most civilized thing in the world - Ernest Hemingway
Wine makes daily living easier, less hurried, with fewer tensions and more tolerance - Benjamin Franklin
