Dodd-Frank at War with Itself

A lot has happened in the four years since Dodd-Frank became law. Many rules were proposed, approved and implemented, and many more are on their way. As rules are adopted, however, it becomes even clearer than it was when Dodd-Frank became law that it does not live up to its official name -- the Wall Street Reform and Consumer Protection Act. Dodd-Frank is keeping regulators busy and causing companies to endure costly changes, but the promised reform and protection are not materializing. It is time to admit defeat and rethink our strategy.

Reassessing our approach requires us to answer a fundamental question: What problem are we trying to solve? We certainly do not want to experience another financial crisis, the attendant costs to taxpayers, job losses and home foreclosures. But we are likely to do exactly that if we do not face the problem that got us into that dire situation.

A constant theme running through the problems we saw in the crisis was regulatory distortion of market decision-making. Think about the government policies that drove home construction and purchases, subsidized mortgages and encouraged investors to buy highly rated mortgage-backed securities without regard to the quality of the underlying loans. Banking and securities regulators directed investors to use ratings as a proxy for quality.

Or think more broadly about the effect of past government interventions to prevent firms (and their creditors) that made bad decisions from reaping the consequences of those decisions. As a result of bailout expectations, shareholders and creditors grow careless about monitoring companies. Along those same lines, government deposit insurance virtually eliminates the need for bank depositors — even very large ones — to pay any attention to the safety and soundness of their banks. And tax advantages given to debt encourage companies to rely on borrowed money, even though doing so could impair their ability to weather crises.

In all of these cases, government — through poorly considered regulations, subsidies or guarantees — nudges companies and individuals to act in a way that they otherwise would not. The government pushed companies and individuals in economically unsound directions. A financial crisis resulted.

Dodd-Frank is an understandably intense response to the crisis -- but in light of the problems' source, it is also a puzzling response. Rather than eliminating government distortions, Dodd-Frank and its regulations add new ones. Dodd-Frank doesn't touch Fannie Mae and Freddie Mac, and new mortgage regulations favor the loans these companies guarantee. Instead of cutting back deposit insurance, Dodd-Frank expands it. Rather than unblocking market incentives to conduct sound underwriting before making any loan, one title of Dodd-Frank directs government to subsidize certain uneconomic loans. Rather than making sure the bankruptcy code is workable for any failing firm, regulators were given the power to identify financial firms that will never be allowed to fail.

Dodd-Frank attempts to counterbalance its bad government incentives by providing regulators with additional powers to prevent companies and individuals from using them. The Financial Stability Oversight Council was created in part to identify any unhealthy risk-taking. The Federal Reserve Bank got more authority over strategic decision-making by banks and non-bank financial institutions. The Volcker Rule enables financial regulators to draw lines between acceptable and unacceptable trading activity by banks. The new regime for over-the-counter derivatives directs regulators to impose very prescriptive clearing, trading and business conduct rules on transactions between sophisticated parties.

The implementation process is teaching us just how tricky it can be to offset bad government incentives with more regulatory discretion. Major rule-making projects are plagued with difficulties. As the regime for clearing and trading formerly over-the-counter derivatives comes online, people worry — quite legitimately — that a big, central clearinghouse could fail with disastrous consequences. Regulating away the possibility of such a failure is no easy task in the face of the regulatory push for clearing. The Financial Stability Oversight Council's attempts to single out certain firms for special regulation fuel concerns that some firms enjoy a government guarantee of perpetual survival.

The multi-regulator attempt to draft a reasonable Volcker Rule was protracted and difficult because regulators realized that how they drew lines would have direct effects on how particular securities trade, and therefore, on their value to investors. As the Securities and Exchange Commission expands the regulatory framework for credit rating agencies, investors are likely to feel even more secure relying on their ratings with no questions asked. And because the Fed is regulating more kinds of financial institutions with a heavier hand, concerns are rising over whether homogenization of the financial system undermines its stability. The FDIC struggles to craft a credible resolution regime that does not simply intensify the too-big-to-fail problem.

Rather than hope in Dodd-Frank’s hyper-regulatory solutions, we should look for ways to eliminate government distortions. We should craft simple rules that force financial institutions — under the watchful eyes of their creditors, shareholders and counterparties — to make prudent choices about their size, structure, funding sources and assets. Reforms might include rooting government guarantees and subsidies out of the housing finance system; strengthening the bankruptcy regime so that creditors know which rules will apply should the firm run into trouble; eliminating risk-weighting from our capital regime; and curbing shareholders' risk appetite with the prospect of additional losses if things go badly at their firms. These rules would be less costly from a regulatory perspective, but many financial institutions would dislike them because the price for that lower regulatory compliance bill would be an elimination of government subsidies and incentives for taking risky actions that do not make economic sense.

The difficulty of Dodd-Frank implementation is not primarily the regulators' fault; the problem comes from Dodd-Frank’s determination to rely on government regulation as a cure for government policy distortions. Instead, let’s work on getting rid of the distortions that encourage people to behave foolishly at the peril of our financial system.