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Dodd-Frank Remains a Troubled Work in Progress

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It has been more than five years since the financial crisis began and more than two years since the passage of the legislative response, the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The nature and magnitude of the effects of the largest piece of financial legislation in generations will become clearer as regulators exercise the broad discretion given them under the act. Regulators’ efforts at implementation are far from complete, with many of the rules still unwritten and others not yet in effect. Regardless of how the rules are written, the act will certainly have far-reaching effects on the financial system and our economy.

As is typical of crisis legislation, Dodd-Frank included many provisions created in haste and many other provisions drafted before the crisis for which the act provided a convenient legislative vehicle. Even as the law was being passed, its proponents acknowledged its imperfections. In the years since the law’s passage, the fundamental flaws with the legislation have become more evident. Dodd-Frank not only failed effectively and holistically to respond to the crisis, but it also gives rise to a whole new set of problems that could overshadow the act’s good elements and lay the groundwork for a future financial crisis.

Many of the provisions in Dodd-Frank are entirely unrelated to the crisis. Other provisions, while purportedly solutions to real problems that emerged in the crisis, could serve to exacerbate those problems. The most striking omission of the act was its failure even to attempt to reform the broken housing-finance system in the U.S. The failure to act was not for want of workable solutions, but was a result of the interest special-interest groups have in maintaining the status quo.

Dodd-Frank’s proponents portray it as a solution to the “too-big-to-fail” problem that led to the massive bailouts during the financial crisis. A closer look at Dodd-Frank suggests that it not only failed to solve the “too-big-to fail problem”, but it also institutionalized the problem by allowing for the designation of systemically important firms, concentrating risk in a new set of large, interconnected derivatives clearinghouses, and deepening the government’s involvement in the mortgage market.

The companion of Dodd-Frank’s entrenchment of big financial companies is its adverse effect on small ones. With its numerous and incomprehensible complexities, Dodd-Frank gives big banks a competitive edge over their smaller rivals, who are less able to hire the lawyers and compliance personnel necessary to advise on complying with the law in the most cost-effective manner. The effects on small banks may be one of the most profound unintended consequences of a law designed to rein in big banks, but only time will tell.

Dodd-Frank creates a regulatory system that suppresses market discipline in favor of regulatory expertise and broad regulatory authority. Congress left key decisions to regulators; it afforded them tremendous discretion to define the limits of their own authority and places unrealistic expectations upon them. The underlying assumption that regulators can effectively micromanage the market is flawed. Giving regulators more levers to pull and buttons to push with respect to the financial system only creates a false sense of security. The new regulatory powers come with few meaningful accountability checks.

So much of the decision-making was left to regulators that the full implications of the law may not be known for years.  Although the implementation process is not keeping pace with statutory requirements, adverse consequences for consumers are already coming to light.  Consumers increasingly will face a one-size-fits-all market that costs more and offers fewer choices. Another less obvious ramification of Dodd-Frank is that it distracts regulators from their core missions by blithely sending them down the hazy trail of systemic risk, a trail entirely devoid of meaningful markers.

Looking behind the act’s celebrated objectives shows that it not only fails to achieve many of its stated goals, but it also reinforces dangerous regulatory pathologies that became evident during the last crisis and creates new pathologies that could lay the groundwork for the next crisis.

Hester Peirce is a senior research fellow at the Mercatus Center at George Mason University and was on the staff of the Senate Banking Committee during the drafting of Dodd-Frank. James Broughel is the program manager of the Regulatory Studies Program at the Mercatus Center at George Mason University. This post is excerpted from their book “Dodd-Frank: What it Does and Why it's Flawed."

 

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Comments (4)
Dodd-Frank will go down in history the financial industry equivalent of the Dred Scott decision. It should have been named the "We'll Torture Bankers and Take Their Money Whenever We Please Act."
Posted by Bob Newton | Thursday, January 10 2013 at 12:18PM ET
The time has arrived for a serious evaluation of what in DFA is working and what is not. It is no criticism of the advocates of the legislation to suggest that there is room for reconsideration. That should be standard practice for any regulatory program as long as human judgment and foresight remain limited. This important book, the work of the Bipartisan Policy Center, and others who are serious about good and effective financial supervsion that actually makes things better should be part of that review.
Posted by WayneAbernathy | Friday, January 11 2013 at 11:56AM ET
Good and useful piece. Definitely not addressing housing policy in the US was a significant element left out. TBTF is very much still a problem especially when leverage and liquidity rules are watered down or not enforced. However, it is important to point out a number of other points. Dodd-Frank remains a 'troubled work in progress' because of tremendous lobbying against every component of the law. Secondly, the SEC and CFTC especially are hamstrung by having budgets delayed and lessened. Also, Dodd-Frank does not create a 'regulatory system that suppresses market discipline in favor of regulatory expertise and broad regulatory authority.' Market discipline can only occur when there is transparency about banks' on- and off-balance sheet risks. Basel III Pillar III already exists with guidelines on this, but Pillar III is either not implemented yet as in the US or it is implemented and supervised unevenly as in Europe. Mayra Rodriguez Valladares
Posted by MRVAssociates | Friday, January 11 2013 at 4:36PM ET
The attitude that every effort to make the provisions of DFA work better in practice is "tremendous lobbying against every component of the law" feeds the Washington paralysis that never fixes anything. It is time to set such attitudes aside and face DFA in a reasonable, bipartisan manner.
Posted by WayneAbernathy | Friday, January 11 2013 at 4:47PM ET
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