Dodd-Frank Critique

Critique on the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted on 21st July 2010, was in response to the Great Recession that shook the financial foundations of the US in the previous years. At the outset, it proposes "the consolidation of regulatory agencies, elimination of the national thrift charter, and a new oversight council to evaluate systemic risk". President Obama announced it as a "sweeping overhaul of the United States financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression". Indeed the scale of this reform is, amongst other indicators, is reflected in the mammoth size of the document itself: the length of the original legislation was a striking 848 pages! Still, authorities are constantly making additions to it, and the document now spans well over 2000 pages. To bring its enormity into perspective, here are a few facts about other similar legislations: The National Bank Act--the law that set up America's banking system in 1864--ran up to 29 pages and the Federal Reserve Act of 1913 to 32 pages. Even the Banking Act that transformed American finance after the Wall Street Crash--commonly known as the Glass-Steagall act--was only 37 pages long. However, whether the effectiveness of the legislation is directly proportional to its length or not is a matter of debate. Empirical data would suggest otherwise. Shorter legislations tend to be more effective than their counterparts, as lengthy and convoluted regulations are an invitation to the banks to seek out loopholes in their rhetoric. The multitude of complex rules in the Dodd-Frank legislation further concentrates power in the hands of the 'big banks' by giving them a huge comparative advantage over smaller ones. This is because such intensive financial regulation would require banks to have large compliance departments, which only the big banks can afford due to their economies of scale. This, therefore, poses an obstruction to the growth of community banks. In fact, since 2010, the market share of community banks has declined at a rate double (12%) than between 2006-2010 (when it was 6%) . But the formidable size and density of Dodd-Frank is only one part of the story. Dodd-Frank also seems to be fundamentally different from any preceding laws of its kind. In fact, Jonathan Macey of Yale Law School notes: "Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies". Despite all these issues, the main reason why Dodd-Frank has been subject to intense debate over the years is the fatal flaws its proposals are riddled with. The defects in Dodd-Frank become conspicuously apparent from the very first title itself. This title established the Financial Stability Oversight Council and the Office of Financial Research, whose jobs include identifying threats to the financial system from both financial and non-financial organizations. At its face value, it seems to be fair measure. According to the conclusions of the Financial Crisis Inquiry Commission, "scant regulation" (16) indeed was one of the leading reasons behind the financial collapse that took a toll on several of the nation's behemoth financial institutions. So yes, if successfully implemented, better regulation may truly be the redeemer of our financial markets. The only issue, however, is its 'successful implementation'. Despite being governed by an overarching set of principles, markets are dominated by an air of uncertainty associated with the collective psychology of people. This makes financial supervision quite hard in itself, and using it to weed out potential threats for the economy still harder. To make things clearer, let us consider one of the many indicators used to monitor financial markets: stock prices. One of the most important characteristics of share prices, as highlighted by every financial collapse, is that they plummet rather than decline steadily. In such a case, it is very unlikely that anyone can accurately predict which firm might be the next failure. Consider the example of Bear Stearns, just a week before it went under. On March 11th 2008, its price per share stood at a decent $70. However, the following Monday, its share price fell cataclysmically to $2! Such drastic fluctuations makes one skeptical of how authorities might predict this prior to its occurrence. While actual risk assessment involves much more, this example of share prices serves to highlight its inherent uncertainty that the government seems to have effectively overlooked. Dodd-Frank, interestingly, has not addressed what could well be one of the leading causes of the financial crisis: exorbitantly high leverage ratios. The capital ratio requirements set down by Basel III requires banks to hold 4.5% of common equity (up from 2% in Basel II) of risk-weighted assets . Such low requirements gives firms ample room to transform themselves into highly leveraged institutions. This, not surprisingly, was a main cause for the recession of 2007-8. Alan S. Blinder, in his article for New York Times, rightly highlights: "before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1" . The FCIC even pointed out some extreme cases: "Fannie's and Freddie's combined leverage ratio, including loans they owned and guaranteed, stood at 75 to 1". Such gigantic leverage ratios would require only a minuscule drop in the value of the company's assets to render them bankrupt. In fact, natural fluctuations in the daily stock market could be solely sufficient to wipe out these firms! Despite the potential threat this presents to the US economy, unfortunately, there has been minimal interest to amend this perilous situation. Contrary to what it claims to have done, Dodd-Frank has actually brewed a perfect recipe to create panic amongst investors. It has given the Federal Reserve and some other government organizations the authority to take over a potentially harmful financial institution. However, given the complexity of the information underlying the Fed's decision, the odds of it being a false call are quite high. But once the news of a takeover hits the stands, creditors are likely to imagine the worst and run on the institution, even if there is no issue. This is akin to the case of the Tylenol scare in 1982. Seven deaths caused by a few bottles of Tylenol laced with potassium cyanide had the potency to render millions of bottles of 'safe' Tylenol useless, as people no longer trusted them . While Johnson and Johnson eventually managed to rein in the situation, consequences of such cases often tend to be skewed towards the negative end of the spectrum. In the financial world, such desertion by consumers is what transforms these nightmares into reality. In fact, the onset of the financial meltdown in 2008 raised doubts on the credibility of most financial institutions, leading to bank runs and consequential large-scale bankruptcies which further exacerbated the crisis. This calls for a rethought on the part of the government about publicly taking over suspicious institutions, keeping in mind the delicate nature of people's trust in the markets. Further, the legislation also demands that large financial institutions undergo 'stress-tests' to determine their resilience to financial fiascos. It, however, has not outlined what such a test would be comprised of. The Fed's vice chairman, Stanley Fischer, said in a speech last month that giving banks a clear road map for compliance might make it "easier to game the test". Compliance is indeed easier when you know what the law requires, but isn't that the whole point of the rule of law? Lastly, Dodd-Frank also enforces measures to "orderly liquidate" institutions in perilous situations. What this measure fails to take into account is the fact that all major financial institutions hold similar assets and function in parallel ways. The conditions that lead to the demise of one could very well be the death call for the others. In such a situation, if the Federal Reserve sets out to liquidate all these companies at the same time, then it might end up dumping the market with an excess of assets, thereby earning little for them. In effect, as well intentioned as it may have been, the elaborate Dodd-Frank legislation is a far cry from what our economy currently needs as a fix. While there are relatively simpler solutions to the issue--decreasing leverage ratios, for instance--, they are often overlooked, perhaps because they might be 'too effective' for the bankers to like. In such a society where politics is deeply entwined with finance, it might be in our best interests to first address the collusion between the banks and government officials. Once this has been eradicated, effective financial reforms will likely face a less adverse gradient during implementation.

"Too Big Not to Fail." The Economist. The Economist Newspaper, 18 Feb. 2012. Web. 07 Oct. 2015.

Blinder, Alan S. "Six Errors on the Path to the Financial Crisis." The New York Times. The New York Times, 24 Jan. 2009. Web. 07 Oct. 2015.

"Tylenol Scandal and Crisis Management." Tylenol Scandal and Crisis Management. N.p., n.d. Web. 07 Oct. 2015.