Dodd-Frank Most Likely To Be At the Root Of a Future Crisis

In an op-ed last week, Treasury Secretary Lew defended Dodd-Frank against efforts by the new Congress to reform the financial law. In his view, changing-or even suggesting changes to-Dodd-Frank seems to be tantamount to inviting another financial crisis. Far from being the cornerstone of a new era of financial stability, however, Dodd-Frank is more likely to be at the root of a future crisis.

Secretary Lew argues that Dodd-Frank has "made our financial system safer and more resilient, and consumers, investors and taxpayers are now protected from the types of abuses that helped cause the crisis." Before we kick back and enjoy this new Dodd-Frank era of financial stability, let's take a closer look at whether the new financial regime will work.

Dodd-Frank builds upon the crisis prevention mechanisms that failed us last time. Contrary to the deregulation mythology, the financial industry was highly regulated prior to the crisis. Some of those regulations gave banks a financial incentive to invest in securities that ran into deep trouble during the crisis. Others encouraged financial institutions to make loans to borrowers that would have difficulty repaying. Still other regulations caused investors to rely on credit ratings rather than looking at underlying credit quality. Meanwhile, the industry's many regulators failed to identify building problems at the financial institutions under their watch.

Dodd-Frank's approach to financial stability simply intensifies the pre-crisis dependence on governmental regulators to shape the financial industry through regulatory prescription and proscription. In weakening the ability of market participants to make their own decisions, the law makes it less likely they will reap the consequences of bad decisions. I.e., if regulators are pulling most of the strings, the industry will expect a taxpayer bailout if there is a problem.

Dodd-Frank puts regulators in the driver's seat in numerous ways. Under Title I of the Act, for example, the Federal Reserve makes decisions regarding risk-based capital, liquidity, concentration, and risk-management at systemically important firms. Under Title II of the Act, regulatory whim is enough to force a company to be wound down outside of the standard bankruptcy process. Under Title VII of Dodd-Frank, regulators decide whether, how, and where over-the-counter derivative products are traded and cleared. The Consumer Financial Protection Bureau, established by Title X of the Act, has changed the mix of products that financial services firms offer to consumers.

Enhancing regulatory powers may seem like a good way to prevent people at financial companies from doing stupid or greedy things. Regulators, however, also do stupid and greedy things. The stakes are higher when regulators make mistakes because regulatory influence is not limited to one firm.

If a firm relies on a flawed model to estimate its vulnerabilities or incompetent risk managers to assess a new product, it might get itself into trouble. It will lose money, and the responsible individuals may lose their jobs. If allowed to fall on the responsible parties, such consequences breed a healthy caution.

When regulators apply a flawed model to assess firms' resilience or give their blessing to a bad product, they can put an entire industry or the whole financial system at risk. Widespread failure, government bailouts, and calls for yet more regulation are likely to follow. That's what happened in the last crisis, and we got Dodd-Frank, which only intensifies our regulatory addiction.

Dodd-Frank supporters take comfort in the fact that the regulatory powers are now housed in purportedly more capable hands than they were prior to Dodd-Frank. For example, the Office of Thrift Supervision (OTS)-AIG's much maligned consolidated regulator (meaning the regulator charged with overseeing the whole company, as opposed to an individual piece of it) is gone. The Fed is AIG's replacement consolidated regulator.

A recently released redacted report by the Fed's Office of Inspector General in connection with the Fed's failure to prevent JPMorgan's notorious "London Whale" derivatives losses a couple years ago illustrates the Fed's susceptibility to the same the problems that plagued the OTS. The Inspector General explains that the New York Fed-JPMorgan's consolidated supervisor-ran into a number of problems during the critical time period that prevented it from stopping the Whale. Among these, the New York Fed was busy with other priorities. It made significant structural changes to the way it oversaw large financial institutions. The team overseeing JPMorgan changed, and the institution-specific knowledge was not transferred to the new team. The New York Fed's coordination with JPMorgan's primary supervisor, the Office of the Comptroller of the Currency, was lousy. As a result of these problems, the New York Fed did not follow up on the Whale-related concerns it identified.

The New York Fed's problems in overseeing JPMorgan were remarkably similar to the OTS's AIG oversight challenges. OTS identified AIG's derivatives unit as a potential source of problems, but failed adequately to follow up. The OTS faced competing priorities, structural changes to its large firm consolidated supervision program, changing team members, inadequate knowledge transfer, and poor coordination with other regulators.

The New York Fed pledges to correct the problems identified by the Inspector General, but reform efforts will be no match for human and organizational obstacles to perfect monitoring. There's a better way than relying on regulators to get their supervisory houses in order. Faced with the fear of losing their own money, we should look to the AIGs and JPMorgans of the world and their creditors to watch for problems. As long as Dodd-Frank stands in the way of this natural form of supervision by promising to keep companies up and running through regulatory measures, the financial system is at great risk.

Hand-wringing over tweaks to Dodd-Frank is warranted, but not because the tweaks will destroy an effective law. The real cause for concern is that these tweaks are inadequate to address the fundamental flaw at the heart of Dodd-Frank-the displacement of market discipline by regulatory oversight. Tweaking the law-if done properly-can help to lessen the law's costs and unintended consequences, but only more sweeping changes will stop Dodd-Frank from undermining the nation's financial stability.