January 31, 2012

Setting Ourselves up for Another Crisis

Hester Peirce

Former Senior Research Fellow
Summary

Dodd-Frank created new problems that could be the cause of the next crisis.

Contact us
To speak with a scholar or learn more on this topic, visit our contact page.

Many Americans assume that Dodd-Frank, the big financial reform bill that became law in July 2010, will protect us from another financial meltdown. This assumption is built on the promises coming from Washington, DC, but as with many guarantees coming from inside the beltway, these assurances should be received with some degree of skepticism.

Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), has been one of the most vocal proponents of the argument that Dodd-Frank will prevent another crisis like the one we just lived through. In a speech he gave on Friday, Chairman Gensler suggested that the costs of the new regulatory system do not matter when they are weighed against “the eight million jobs lost, millions forced out of their homes, and the uncertainty throughout the economy that came from risk, which spilled over from Wall Street.” We all agree that the crisis was terrible and hurt many innocent people, but neither the chairman nor his agency has demonstrated that the particular rules the agency is adopting would have prevented these things from happening. What is worse, rather than lowering the risks to the financial system, the CFTC’s regulations could actually create the groundwork for another financial crisis.

Just one example is the way derivatives, the financial products that companies use to manage their risks, are being forced into central clearinghouses. These clearinghouses are special entities that place themselves between the buyer and the seller in transactions, meaning the seller doesn’t have to worry about the buyer holding up its end of the bargain and vice versa. Instead, both the buyer and seller look to the clearinghouse, which is intended to be fail-proof. Unfortunately, these clearinghouses might not end up being as safe as everyone hopes. The CFTC’s own rules, in some instances, actually threaten to undermine risk management. For example, the CFTC designed its rules so that clearinghouses would have to offer membership to firms like MF Global (the firm that recently failed and, in the process, appears to have lost $1.2 billion of customer funds). Clearinghouses are a useful innovation, but only if they are extremely careful risk managers.

If a major clearinghouse fails, a financial crisis is likely to follow because clearinghouses, by their very nature, have relationships with firms all across the financial industry. When a clearinghouse melts down, all the firms with which it has relationships will suffer, and some could even fail. In short, don’t believe the promises you hear about the financial system being more secure than it was before the crisis. While failing to address the problems that led to the last crisis, Dodd-Frank created new problems that could be the cause of the next crisis.