A critical assessment of the Dodd-Frank Wall Street Reform and Consumer Protection Act

By Viral Acharya, Professor of Finance, Stern School of Business, New York University, Thomas F. Cooley Professor of Economics, Stern School of Business and Faculty of Arts and Science, New York University, Matthew Richardson, Professor of Applied Economics, Stern School of Business, New York University, Richard Sylla, Professor of Economics, Stern School of Business, New York University and Ingo Walter, Seymour Milstein Professor of Finance, Corporate Governance and Ethics at the Stern School of Business, New York University. Cross-posted from VoxEU.

The Dodd-Frank Wall Street Reform and Consumer Protection Act is widely viewed as the most sweeping set of reforms to the US financial sector since the Great Depression. Yet despite being broadly in favour of the measures, this column identifies flaws that fail to deal with the main causes of the crisis and that will lead to further implicit government guarantees.

The global crisis started in US financial markets (Cecchetti 2007). US financial reform was thus always going to be a central pillar in the world’s effort to avoid such crises in the future (Baldwin and Eichengreen 2008, Reinhart 2008, Acharya and Richardson 2009). After long deliberation and political haggling, the reform is finally ready in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This is widely described as the most ambitious and far-reaching overhaul of financial regulation in the US since the 1930s. Together with other regulatory reforms introduced by the Securities and Exchange Commission, the Federal Reserve (the Fed), and other regulators in the US and Europe, it is going to change the structure of financial markets in profound ways.

In our forthcoming book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, we provide our overall assessment of the Act in three different ways:

  • From first principles in terms of how economic theory suggests we should regulate the financial sector;
  • In a comparative manner, relating the proposed reforms to those that were undertaken in the 1930s following the Great Depression;
  • How the proposed reforms would have fared in preventing and dealing with the crisis of 2007 to 2009 had they been in place at the time.

This column provides a summary of some of the highlights.

The goal
The critical task for the Dodd-Frank Act is to address this increasing propensity of the financial sector to put the entire system at risk and eventually to be bailed out at taxpayer expense. Does the Dodd-Frank Act do the job? Before answering that, here are the Act’s highlights:

  • Identifying and regulating systemic risk. Sets up a Systemic Risk Council that can deem non-bank financial firms as systemically important, regulate them, and, as a last resort, break them up; also establishes an office under the US Treasury to collect, analyse, and disseminate relevant information for anticipating future crises.
  • Proposing an end to too-big-to-fail. Requires funeral plans and orderly liquidation procedures for unwinding of systemically important institutions, ruling out taxpayer funding of wind-downs and instead requiring that management of failing institutions be dismissed, wind-down costs be borne by shareholders and creditors, and if required, ex post levies be imposed on other (surviving) large financial firms.
  • Expanding the responsibility and authority of the Federal Reserve. Grants the Fed authority over all systemic institutions and responsibility for preserving financial stability.
  • Restricting discretionary regulatory interventions. Prevents or limits emergency federal assistance to individual institutions.
  • Reinstating a limited form of Glass-Steagall (the Volcker Rule). Limits bank holding companies to minimal investments in proprietary trading activities, such as hedge funds and private equity, and prohibits them from bailing out these investments.
  • Regulation and transparency of derivatives. Provides for central clearing of standardised derivatives, regulation of complex ones that can remain traded over the counter (that is, outside of central clearing platforms), transparency of all derivatives, and separation of non-vanilla positions into well-capitalised subsidiaries, all with exceptions for derivatives used for commercial hedging.

In addition, the Act introduces a range of reforms for mortgage lending practices, hedge fund disclosure, conflict resolution at rating agencies, requirement for securitising institutions to retain sufficient interest in underlying assets, risk controls for money market funds, and shareholder say on pay and governance. And perhaps its most popular reform, albeit secondary to the financial crisis, is:

  • Creation of a Bureau of Consumer Financial Protection (BCFP). This will write rules governing consumer financial services and products offered by banks and nonbanks.

Assessing the Dodd-Frank Act
Does the Act address the key issues? Our first reaction is that it certainly has its heart in the right place. It is highly encouraging that the purpose of the new financial sector regulation is explicitly aimed at developing tools to deal with systemically important institutions. And it strives to give prudential regulators the authority and the tools to deal with this risk. Requirement of funeral plans to unwind large, complex financial institutions should help demystify their organisational structure – and the attendant resolution challenges when they experience distress or fail. If the requirement is enforced well, it could serve as a tax on complexity, which seems to be another market failure in that the private gains far exceed the social ones.

In the same vein, even though the final language in the Act is a highly diluted version of the original proposal, the Volcker Rule limiting proprietary trading investments of Large Complex Financial Institutions provides a more direct restriction on complexity and should help simplify their resolution.

The Volcker Rule also addresses the moral hazard arising from direct guarantees to commercial banks that are largely designed to safeguard payment and settlement systems and to ensure robust lending to households and corporations. Through the bank holding company structure, these guarantees effectively lower the costs for more cyclical and riskier functions such as making proprietary investments and running hedge funds or private equity funds. Yet commercial banking presence is not critical in these already thriving markets.

Equally welcome is the highly comprehensive overhaul of derivatives markets aimed at removing the veil of opacity that has led markets to seize up when a large derivatives dealer experiences problems (Bear Stearns, for example). Centralised clearing of derivatives and the push for greater transparency of prices, volumes, and exposures – to regulators and in aggregated form to the public – should enable markets to deal better with counterparty risk, in terms of pricing it into bilateral contracts, as well as understanding its likely impact. The Act also pushes for greater transparency by making systemic nonbank firms subject to tighter scrutiny by the Fed and the Securities and Exchange Commission.

Despite this, when read in its full glory, some experts have dismissed the 2,300+-page script of the Dodd-Frank Act out of hand. The Act requires over 225 new financial rules across 11 federal agencies. The attempt at regulatory consolidation has been minimal and the very regulators who dropped the ball in the current crisis have garnered more, not less, authority.

Given that the massive regulatory failure of the financial crisis needs to be fixed, however, what other options do we have? Given a choice between Congress and the admittedly imperfect regulatory bodies designing the procedures for implementing financial reform, it would not seem to be a difficult decision.

The shortcomings
That said, from the standpoint of providing a sound and robust regulatory structure, the Act falls flat on at least four important counts:

  • The Act does not deal with the mispricing of pervasive government guarantees throughout the financial sector.

This will allow many financial firms to finance their activities at below-market rates and take on excessive risk.

  • Systemically important firms will be made to bear their own losses but not the costs they impose on others in the system.

To this extent, the Act falters in addressing directly the primary source of market failure in the financial sector, which is systemic risk.

  • In several parts, the Act regulates a financial firm by its form (bank) rather than function (banking).

This feature will prevent the Act from dealing well with the new organisational forms likely to emerge in the financial sector – to meet the changing needs of global capital markets, as well as to respond to the Act’s provisions.

  • The Act makes important omissions in reforming and regulating parts of the shadow banking system that are systemically important.

It also fails to recognise that there are systemically important markets – collections of individual contracts and institutions – that also need orderly resolution when they experience freezes.

Bottom line
The net effect of these four basic faults is that implicit government guarantees to the financial sector will persist in some pockets and escalate in some others. Capital allocation may migrate in time to these pockets and newer ones that will develop in the future in the shadow banking world and, potentially, sow seeds of the next significant crisis. Implementation of the Act and future regulation should guard against this danger.

In the end, we applaud the Dodd-Frank Act’s ambition and its attempt to rewrite financial sector regulation. The Act does represent the culmination of several months of sincere effort on the part of the legislators, their staffers, the prudential regulators, academics, policy think tanks, and, of course, the financial industry (and the lobbyists).

But it is equally important to recognise that the most ambitious overhaul of the financial sector regulation in our times does not fully address private incentives of individual institutions to put the system at risk, it leaves a great deal of uncertainty as to how we will resolve future crises, and it is likely to be anachronistic, in parts, right from the day of its legislation. Not all is lost, though, and these limitations can be fixed in due course. To understand how, read our book.

This article is based on Prologue of the forthcoming book “Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance”, NYU-Stern and John Wiley & Sons, October 2010.
Acharya, Viral and Matthew Richardson (2009), “Repairing a failed system”, VoxEU.org, 7 February.

Baldwin, Richard and Barry Eichengreen (2008), “Rescuing our jobs and savings: What G7/8 leaders can do to solve the global credit crisis”, VoxEU.org, 9 October.

Cecchetti, Stephen (2007), “Federal Reserve policy actions in August 2007: Frequently asked questions (updated)”, VoxEU.org, 15 August.

Reinhart, Carmen M (2008), “Reflections on the International Dimensions and Policy Lessons of the US Subprime Crisis”, VoxEU.org, 15 March.

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  1. Random Blowhard

    The Dodd-Frank reforms are not worth the paper they are written on as the key ingredient – the POLITICAL WILLPOWER to end TBTF does not exist in either party. Nothing short of full blown economic meltdown ala Iceland or Argentina OR armed REVOLUTION on the streets will end TBTF. Unfortunately that is exactly where we are headed.

  2. F. Beard

    How does one regulate an inherently dishonest and unstable system, government backed fractional reserve banking?

    Must we endure another 300 years of attempts to fix the unfixable? Is God mocked by systematic, government backed violation of “Thou shall not steal”?

    Sadly, I guess we’ll see, one more time, perhaps our last time.

  3. jake chase

    Dodd Frank is cosmetic, inept, degenerate, futile, legislative extend and pretend, just what one can expect from its cosponsors. Can’t wait for the book. Should make a great paper weight.

  4. Donald Deadbeat

    One is left with the impression that the legislation is of the half-glass empty type. I’m not sure why the author points out some of the good, but taxpayers will be on the hook again once the looting goes off the rails. Whole neighborhoods have been destroyed and millions are out of work:

    “Truth be told, the fundamental change we so desperately need in our financial regulatory system is now more uncertain than ever. Not only does the Dodd-Frank Wall Street Reform and Consumer Protection Act lack any truly substantive reforms that can protect Main Street and individual investors, but the sheriffs given the shiny gold badges to implement what little protections are in place, are the very same Wall Street lobbyists and regulatory agencies that are responsible for the crisis in the first place.”

  5. AndyC

    “Requires funeral plans and orderly liquidation procedures for unwinding of systemically important institutions, ruling out taxpayer funding of wind-downs and instead requiring that management of failing institutions be dismissed…………”

    So whens the funeral?

  6. Indigenous Centurion

    Reform and Consumer Protection Act is widely viewed as the most sweeping set of reforms

    Had governments not mangled our money to begin with, no reform would be now needed. Are they now reforming themselves, or merely giving us a kiss and a promise? We cannot wait for government.

    Don’t get mad, Steven! Get even! Teach your children to avoid credit, avoid credit ratings, pay cash for everything, learn to muddle through without buying their garbage, their by-products, their seconds, their leftovers. Teach children to grow their own food, deliver their own flowers, wrap their own packages, and fabricate their own birth control strategy.

    Keep them in suspense!


  7. Hugh

    NYU is where Nouriel Roubini hangs out so I’m guessing this is more or less the Roubini line even if his name doesn’t appear on it.

    I get the feeling that if these guys had been around in 1912 they would have been applauding the White Star line even though the Titanic had just sunk.

    I find it just about obscene that they liken the flimsy Volcker rule to Glass-Steagall. I mean whom are they trying to fool?

    And what is this garbage about the act having its heart in the right place? This just seems like an oblique admission that the act doesn’t do what it is supposed to.

    Of the three approaches they cite, two are useless. Economic theory has been blown out of the water. Who cares what economic theory has to say about anything? As for applying Dodd-Frank to 2007-2009, again who cares? You can have all the regulation in the world on the books but if the regulators aren’t regulating, if government is giving everyone a wink and a nod, you will still have markets go off the rails and crash.

    The only approach that might have some merit is the comparison to the Great Depression, or more specifically the Crash that preceded it. Even a cursory examination would show how weak Dodd-Frank is with regard to the great acts of the Depression period.

    But do we really need a book on this. Would it not have been more useful to write what the great acts of our own time need to be to fix our financial system now?

    This brings me back to my central criticism of all current economics. They all fail to see that what we currently have is a kleptocracy. They continue to engage in the fiction that markets are basically sound but just have been experiencing problems which various degrees of tinkering should sort out. But a kleptocracy means that the markets are fundamentally unsound, that they are little more than the arena for criminal enterprises. Look at all the frauds in origination in the housing bubble, the subsequent gambling that was securitization, and now foreclosuregate. Look at the years long manipulation of commodities markets and the similar use of HFT in stock markets. Look at all the backdoor bailouts and lobbyist written legislation. Look at financial industry whores, like Dodd and Frank. Now tell me which is the more accurate picture, kleptocracy or a sound system with problems.

  8. Eric L. Prentis

    Banks have three years to implement any changes from the Dodd-Frank law and then another two years, if requested, and then can apply to the government for another two years; a total of seven years before anything has to happen. Bank lobbyists will change this law to the bankers’ liking over the next seven years.

    The three major benefits to the Dodd-Frank law are: 1) audit the Fed, one time, from 12/1/07 to 7/21/10; 2) Consumer Financial Protection Agency—–major detriment, located in the Fed; and 3) we now have explicit resolution authorization to break-up failed “too big to fail banks.” Of these, bank resolution is most important, which we soon will need.

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