22 July marks the first anniversary of the signing of the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act, the most comprehensive US regulatory effort for financial markets since the 1930s. The financial crisis of 2007-2009 and the accompanying contraction in the global economy made it abundantly clear that the safety and soundness of the world financial system was seriously impaired and required fixing. The US was the first mover among the world’s leading economies in outlining a new regulatory architecture for financial markets. But the US legislation was not a fully formed set of rules or even a set of principles. Rather it outlined a path and a set of critical elements for the new regulatory architecture.
In recognition of the first anniversary of the Dodd-Frank Act’s enactment, The Pew Charitable Trusts and the NYU Stern School organised a conference on “Dodd-Frank: One Year On” at Pew’s offices in Washington, DC. The conference brought together academics, policymakers, and architects of the Dodd-Frank reforms and some of the regulators who are shaping and implementing them. The eBook provides summary remarks and analysis by the participants at this conference offering unique perspectives into current thinking on the Dodd-Frank Act, where the regulatory process stands after one year, and challenges in the years ahead.
The Dodd-Frank Act attempts to address a vast variety of issues: too big to fail, consumer protection, proprietary trading, derivatives clearing and transparency, ratings agencies, executive pay, corporate governance, and so on.
There was uniformity at the conference, even within the group of academics and researchers critical of the legislation, that the Act was a step in the right direction. There was consensus that the pre-Dodd-Frank financial architecture needed fixing and that the effort to reform and repair this architecture had its heart in the right place. But at the end of a long day of free-flowing and candid discussion, there were several issues that remained. We summarise these below.
- Will the new regulatory structure make the financial system more robust to shocks by providing institutions with the tools to heal themselves?
The critical ingredient for the health of the system is adequate capital. The key issue is whether financial firms and market participants will have adequate capital and liquidity to withstand adverse events – those due to idiosyncratic shocks or aggregate shocks. The follow-up query is whether these adequate levels of capital will be privately held. These underlying questions were at the heart of discussions of regulatory capital requirements, both under Dodd-Frank and under Basel III rules. There was broad agreement that the primary concern is aggregate risk, which leads to externalities when the financial sector becomes under-capitalised and provides the raison d'être for regulating bank capital. There were also discussions of where capital requirements should be imposed – at the level of the firm or on markets and transactions – and every time the word “shadow banking” was mentioned, the attractiveness of market- or asset-class level capital requirements – unfortunately, not the focus of Dodd-Frank – became clear.
- Does the Dodd-Frank Act adequately deal with monitoring and measuring systemic risk?
The Dodd-Frank Act assigns new responsibilities to the Federal Reserve to identify systemically important financial institutions (SIFIs). There is a new body, the Financial Stability Oversight Council (FSOC), to be supported by data and research from a new Office of Financial Research () within the US Treasury Department. There were discussions of how this regulatory structure should determine what levels of capital are safe in the event of major shocks to asset markets. There was growing dissatisfaction with the Basel III risk-weights approach and an increasing preference for measures that assessed the systemic risk of financial firms using market data or through regulatory stress tests. Academics are actively researching the issues of how to identify and measure systemic risk, and there is significant progress being made on all fronts. The Treasury’s new research office is developing the data capabilities necessary to support the new oversight council with both information and analysis necessary to monitor the risks in the system. The key unknowns in this effort are how regulators will act on the information as it emerges and whether they will be timely in their response to the accumulation of risk. Again, an important concern is the problem of monitoring risks in the constantly evolving shadow banking system, whose transparency could be enhanced if regulation were to operate at the level of markets or transactions.
- Do the provisions of the Act deal adequately with the problem of too-big-to-fail institutions?
The Dodd-Frank Act prescribes an Orderly Liquidation Authority (OLA) for insolvent financial firms. Enforcement and implementation of this authority are assigned to the Federal Deposit Insurance Corporation. Many details still need to be worked out. There was a lively discussion of whether the OLA framework was conceptually right in wishing to liquidate systemically important financial firms rather than resolve them. Any such resolution would likely entail upfront costs but to the extent OLA plans to primarily collect premiums ex post from surviving financial firms, there was concern that the OLA could distort incentives for firms in the event of a crisis.
At any rate, whether the OLA can effectively deal with a systemic crisis or not will be known only the next time we do have a crisis. Given this uncertainty, concerns were expressed about the constraints imposed on the Federal Reserve that would limit their ability to provide emergency assistance to non-banks, which this crisis has shown can be systemically important. This is a concern since the OLA, as envisaged by the Dodd-Frank, is focused on SIFIs only and not on systemically important markets, such as sale-and-repurchase transactions (“repo”), or herds of small institutions that are systemically important, such as money-market funds.
- To what extent will the Dodd-Frank Act involve the right mix of automatic “stabilisers” (e.g. higher capital requirements), fixed rules (e.g. the Volcker Rule), and discretion (e.g. the Federal Reserve’s ability to lend to illiquid, potentially insolvent, institutions at flexible haircuts) to be an effective framework for financial stability?
This was perhaps the most fundamental underlying question in all of the discussions. As we noted above, conceptual gaps in the design of Dodd-Frank’s Orderly Liquidation Authority raise concerns that in the next financial crisis, as in the last, regulatory discretion and forbearance might take hold as the preferred route of crisis resolution. There was an active discussion about the advantages of building rule-based recapitalisation of institutions directly into their capital structure, as well as upfront capital requirements tied to systemic risk. Such stabilisers were deemed particularly important given that all the evidence – from this crisis and prior episodes – suggests that any fiscal route to recapitalisation in a crisis tends to favour the financial sector’s creditors rather than addressing their under-capitalisation and the induced spillovers to households and the real economy. The great divergence in relative health of large economies and their financial sectors only creates additional risks in coming up with a reasonably well-harmonised regulatory framework, one that sets an adequately high standard rather than the lowest common denominator. These risks from having a globally active and pliant financial sector only make it more imperative that the focus be on rule-based containment of the incidence of financial crises rather than on discretionary attempts to limit the spillovers during crises.
Of course, successful financial regulation needs to strike a balance that encourages innovation and competition, carefully monitors innovations designed to evade regulation, and permits discretion and flexibility on the part of regulators but not so much flexibility that the system is prone to capture by the regulated or the political process. This is a tall order indeed. The Dodd-Frank Act is ambitious in trying to strike this balance. Its implementation in the first year has, however, highlighted several pitfalls. The good news is that the Act does allow the regulators sufficient freedom to chart out the right rules.
And yet, it would be a mistake to think that simply getting Dodd-Frank’s implementation right solves all things that are not well in the financial sector and in the United States. The un-addressed household indebtedness issue, the need to unwind the government-sponsored enterprises (Fannie Mae and Freddie Mac, in particular) in a graceful manner to promote a privately organised but well-capitalised mortgage finance system, and the fiscal readjustments on the government’s balance sheet remain important challenges in parallel.
We hope you enjoy reading the evaluation of the Dodd-Frank Act and possible improvements in the accompanying eBook, which compiles remarks of various participants at the Pew-Stern conference. We are grateful to the various participants and the keynote speakers (Michael Barr and Thomas Hoenig) not only for their contributions but also for the public policy role that they have played in directly or indirectly influencing and implementing financial sector reforms. We are especially indebted to Charles Taylor and Michael Crowley of The Pew Charitable Trusts, whose superb stewardship of the conference has made the conference and this eBook possible, as well as to leading journalists from financial press who moderated the conference sessions and stimulated important discussions on pressing – current as well as long-term – issues. Finally, we thank Richard Baldwin of VoxEU for encouraging us to put this together and Anil Shamdasani of CEPR in binding it all.
Acharya, Viral V, Thomas Cooley, Matthew Richardson, Ingo Walter (eds.) (2011), Dodd-Frank: One Year On. VoxEu.org ebook, July.