July 2, 2014

Dodd-Frank is Not Living Up to Its Promises

Hester Peirce

Former Senior Research Fellow
Summary

Reform should concentrate on removing government barriers to the flow of information, taxpayer safety nets for companies, and regulatory attempts to direct resources toward favored industry sectors and activities.

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This month marks four years since the passage of Dodd-Frank. Slightly more than half of the Dodd-Frank rules are final, according to law firm Davis Polk. This rulemaking pace is not as rapid as many would like. But enough regulations are in place to indicate that Dodd-Frank is not living up to the promises embedded in its official title, "The Wall Street Reform and Consumer Protection Act." Meaningful Wall Street reform and consumer protection requires more creative thinking than Dodd-Frank's tried and tired approach to financial regulation.

Dodd-Frank, the grand response to the financial crisis, arms government regulators with new tools to control private financial institutions in order to maintain financial stability. For example, the Federal Reserve can limit the activities of large bank holding companies. The Financial Stability Oversight Council can designate other systemically important financial institutions and activities for extra regulation. The Securities and Exchange Commission is charged with regulating the credit rating agencies more stringently than it did before the crisis to make sure they get their ratings right this time. The new Bureau of Consumer Financial Protection has broad authority to regulate financial products and services offered to consumers. The Commodity Futures Trading Commission has broad new authorities over derivatives transactions between big companies.

All of these changes might have a surface appeal. After all, during the financial crisis, we saw big, seemingly invincible financial institutions collapsing. Credit rating agencies appeared to be selling their stamps of approval to creators of fundamentally flawed financial products. Consumers took on mortgages they could not afford to repay. Big firms scrambled to protect themselves as the firms that were on the other side of large derivative transactions stumbled.

The case for reform was clear, but the form regulatory changes should take was less clear. Government was part of the failure, and effective reforms would not have brushed regulatory failures under the rug. Instead, reforms should have addressed the sins of both the private and public sectors.

Regulatory missteps included looking the other way or actively intervening to save failed firms, which gave other weak firms an incentive to get in line for their rescues. The SEC gave its blessing to a few credit rating agencies. Along with other regulators, it then forced firms to rely on the work of the favored credit rating firms. Firms got regulatory benefits from holding highly rated products, such as residential mortgage-backed securities. Regulators watched along with almost everyone else as housing prices rose to unsustainable levels, thanks in part to the active participation of Fannie Mae and Freddie Mac, which enjoyed implicit regulatory backing.

The desire to prevent another crisis by adding to the ranks of regulators and supplementing their rulebooks is understandable. But more of the same is not the solution. Regulators, no matter how much discretion and how many resources they have, will never be able to keep up with the dynamic markets. The well-intentioned actions that government takes create unwanted and unanticipated distortions, which can undermine financial stability. We saw that with policies that encouraged investment in housing and debt financing. Layering on new regulations increases complexity, which may simply give firms more opportunities to game the system and keep out less savvy competitors who cannot navigate the complexity to offer their better products and services.

Effective and lasting reform cannot rely on regulatory micromanagement of the markets. Instead, government needs to return responsibility for punishing reckless risk-taking to the markets themselves. Markets can collect and process massive amounts of information quickly and efficiently and use that information to direct resources toward firms that provide products and services that consumers and other market participants value. Markets can decisively punish reckless firms and send signals to other firms not to follow suit. But if the government is unwilling to relinquish its role in picking winners and losers-and in absorbing losses for poor performers-firms will devote their resources towards buttering up the government officials who are charged with making decisions and handing out piles of cash and regulatory favors. Then we will have the worst of both worlds-lots of regulation and a financial system that does not serve consumers and businesses.

Reform should concentrate on removing government barriers to the flow of information, taxpayer safety nets for companies, and regulatory attempts to direct resources toward favored industry sectors and activities.

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