Treasury Secretary Jacob Lew paused in his waning days in office to write a law review article in defense of Dodd-Frank. Warning of “potential challenges to our robust regulatory framework,” Lew seems to fear that the new administration, working with a new Congress, will scrap the post-crisis financial law. We ought rather to fear that Dodd-Frank will not get repealed and replaced with something better.
Secretary Lew credits Dodd-Frank with fixing a broken, outdated regulatory system and thereby helping to restore the economy. The pre-crisis regulatory system—built on government subsidies and distortions caused by well-intentioned, but poorly functioning rules, such as risk-based capital requirements—did need an overhaul. But Dodd-Frank was not the overhaul it needed.
One of the key features of the Dodd-Frank framework, according to Secretary Lew, is that it is “a flexible, forward-looking system focused on carefully monitoring changing financial markets and identifying and addressing emerging risks,” rather than the prior “reactive and inflexible system that regulated piecemeal in response to specific crises.” Lew correctly identifies flexibility and the ability to look to the future as key features of an effective regulatory system. The question is what those elements should look like.
Dodd-Frank gives regulators great flexibility in deciding whom to regulate and how. That kind of flexibility, which flows from nearly unbounded congressional delegations of authority, undermines the rule of law. People considering entering into or investing in a business cannot predict which regulator, let alone which type of regulation, they will face. The regulatory system needs a different kind of flexibility—the ability to adjust rules to market-driven developments in financial products and services. For example, changes may be necessary to accommodate bitcoin, robo-advisers, online marketplace lenders, and the new ways in which companies communicate with investors and potential investors.
Dodd-Frank is forward-looking in the sense that it relies on regulators to be seers—spotting trouble long before anyone working at a financial institution identifies a problem. We see this, for example, in the Financial Stability Oversight Council’s duty to identify and craft special regulation for activities and institutions that might destabilize the financial system. We see it also in Dodd-Frank’s stress testing process, under which regulators’ predictions of what could happen in the future shape key private banks decisions. Even with Dodd-Frank’s new powers, regulators have neither the omniscience nor the omnipotence needed to play the role of interventionist prophet. A financial regulatory system can be forward-looking by relying on the market—with its unrivaled access to on-the-ground information and its ability to transform that information into easy-to-read signals of success or failure. If permitted to operate, mechanisms like short-selling, credit default swaps, and information markets can be much more effective than regulators at sending up warning flares and taking down failing firms.
Secretary Lew highlights Dodd-Frank’s contribution to financial stability. But a number of key pieces of Dodd-Frank—among them, the Volcker Rule, non-bankruptcy resolution, and clearing mandates—could add to instability by, respectively, disrupting bond markets, creating uncertainty for creditors of large financial institutions, and giving rise to new too-big-to-fail institutions.
Eliminating these and other features of Dodd-Frank does not have to mean returning to the pre-crisis status quo. As the House Financial Services Committee’s CHOICE Act illustrates, reform is likely to include new substantive and procedural requirements. Nobody is calling for replacing a financial regulatory system that does not work with the pre-crisis system that did not work.
Instead, it is time for a regulatory system that relies on high, non-risk-based capital requirements for banks, allows firms to vigorously compete for consumers’ business, and places decision-making responsibility with the people who have both the information and incentives (meaning the money on the line) needed to make good decisions. Regulators have a role to play in setting and enforcing strong ground rules, but there is no need for them to try to run the whole financial system or micro-manage individual financial firms.
Although it is understandable that people who have poured years of their lives into implementing a law defend it, costs sunk in furtherance of admirable intentions are not a reason to continue to preserve a flawed regulatory system. It is time to try something new—an approach that embraces market dynamism and doesn’t ask regulators to do the impossible.