July 21, 2010
Dodd-Frank Forum: I Give It a B
Posted by Brett McDonnell

Erik asks us how we would grade the Act as a whole, and whether we would have voted for it.  I seem to be more of a supporter than most posters here:  I would certainly have voted in favor, and I give it a solid B.  Unlike Renee, I think there is a big picture story which helps identify the core provisions.  After decades of deregulation, our financial system has become unstable as players loaded up on leverage and untested innovations, leaving the system vulnerable to episodes of panics and deleveraging which can bring down the entire economy.  There are two complementary stories of leverage and systemic risk.  The too big to fail story focuses on financial giants whose failure would rapidly spread to dozens of other connected firms.  The shadow banking story focuses on the ways that markets like repo, commercial paper, and money market funds resemble banks, with short-term debts financing long-term assets, and hence become subject to runs.  A major side story is the housing market, where the main bubble that led to the panic occurred.  There, securitization and abusive credit products helped create the dubious debts which eventually ignited the system.

The core provisions for addressing system instability are Titles I and II.  We addressed the banking system in the 30s with 3 main elements:  deposit insurance, FDIC resolution authority, and increased banking supervision.  There's no explicit insurance in Dodd-Frank, but the bailouts suggest that the federal government stands ready to prop up a failing financial system.  Title II replicates something close to FDIC resolution authority for a broader range of financial institutions.  One element of Title II that I really like is its push to punish the officers of failed companies, through firing and restitution.  That may go a decent way to mitigate the moral hazard caused by the bailouts.  Title I extends supervision, including regulation of leverage, to a broader range of companies.  It should at least cover the too-big-to-fail companies.  It doesn't break them up, but it does direct regulators to impose heavier burdens on those companies, and gives them the power to break them up if they believe doing so is needed for financial stability.  Title I will probably do less to address smaller companies in the shadow banking system, though as I've noted before that depends on how aggressive the Council is in interpreting its authority.  Title IV (hedge fund advisers) should at least give regulators more information about what is happening in many companies within the shadow banking system.  Title VII address another important source of financial instability, swaps with their counterparty risks that create doubts throughout the system.  The creation of derivative clearinghouses is likely a good idea, although it creates its own risks, and as always the devil is in the details.

Dodd-Frank also addresses the problems in the housing market.  Title X creates the Bureau of Consumer Financial Protection.  Consumer protection and safeguarding financial stability are sometimes in serious tension with each other.  But, abusive credit products can ultimately lead to bad debts that cause problems in the financial system.  That is particularly so when originators sell off many of those debts through securitization, reducing their incentives to make sure loans will be repaid.  Who knows how aggressive the Bureau will be (Elizabeth Warren for Director!).  This idea may not work, but it's worth a try.  Title IX Subtitle D adds a 5% credit risk retention requirement for securitizations.  Again, I'm not sure it will work, but it's a serious attempt to address a real problem.  Finally, Title IX Subtitle C tries many tactics to improve the performance of credit rating agencies.  Most noteworthy are the extension of securities law liability to the agencies, and even more importantly the directive to remove credit ratings from regulatory requirements of all sorts (see sections 939 and 939A).  It's not clear to me exactly how far this goes--to what extent can agencies use credit ratings at all in their various rules?  But this could be a very big deal.  If you believe Frank Partnoy, a key reason for the success of credit rating agencies is that the many rules using credit ratings have created "regulatory licenses"--institutions buy highly-rated bonds in order to comply with administrative rules.  If those regulatory licenses are being eliminated, it may greatly reduce the role of the credit rating agencies.

Those core provisions strike me as serious attempts to address the main problems that the crisis has revealed.  There was even more moaning about the banking and securities acts of the 30s, but they created a regulatory framework that helped bring the longest period of financial stability in American history.  (And a side benefit for us law professors: this creates lots more work for our graduates over the next few years, and boy do they need it.)  Does the Act get at everything?  No, but there are good reasons for not trying to do so, one reason being that no one has any really good ideas about how to address some of the deepest problems.  Does the Act sustain uncertainty with all its forthcoming rules and studies?  Yes, but I argued yesterday that the alternatives aren't any better.  Will there be some bad unintended consequences that need to be fixed?  Of course, but doing nothing would probably be even worse.  We have a vast, unstable financial system which no one really understands in anything like the depth required to adequately regulate it, and yet unregulated it is likely to drive us into a Second Great Depression one of these days (and there's no good reason to think that the First Great Depression is as bad as it can get).  There are no good alternatives available.  Given all that, I think Dodd-Frank is quite a reasonable stab at an impossible task.

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