July 19, 2010
Dodd-Frank Forum: What's Missing--Stumbling in the Shadows
Posted by Brett McDonnell

I'll take a stab at Erik's question as to what's missing from this mammoth bill.  Like Erik, I think the biggest problem area is shadow banking and leverage.  He's right that a part of what's missing is more guidance as to how to measure leverage--although I personally have no idea how to do that in a way that doesn't invite rampant evasion.  But at least as big a problem is who to regulate.  Despite all the focus on "too big to fail," I think that this crisis, like that of the 1930s, illustrates that systemic collapse can occur when many medium-size institutions in linked markets follow similar investment strategies that all go wrong at once, leading to forced attempts to unwind their positions and something that closely resembled a bank run.  It seems to me that is what happened in areas like the repo market and the commercial paper market.  Insofar as the Act leaves the players in the shadow banking system unregulated, it may make matters even worse, as the many new regulations of the banking system "in the light" push more money and talent into the shadows.

Dodd-Frank has at least two parts that start to attack the problem, but they have complementary holes. Title I's regulation of nonbank financial companies that pose a risk to the financial stability of the U.S. will extend quite significant regulation, including regulation of leverage, to a new set of companies.  Much depends upon how broadly the Financial Stability Oversight Council interprets that power, but I fear that it will extend this regulation to only a few very large companies, leaving many smaller players untouched.  Conversely, the new rules for hedge fund and private equity advisers will cover many players within the shadow banking system and give the regulators important new information.  However, that section of the Act (Title IV) extends very little new substantive regulation, and thus does not limit the leverage those companies can undertake.

I also agree with Erik that it's important to focus on pushing regulators to respond to developments in the market.  New rules will lead to new strategies by actors in the markets, and changing circumstances will lead to further innovations.  Financial regulators must always work hard just to play catch up.  But, I'm ever-so-slightly more optimistic than Erik that Dodd-Frank has some provisions that may help.

First, the Financial Stability Oversight Council, which Erik dislikes, seems to me to have some potential.  It brings together the leading regulators who collectively have much information on financial markets, and it directs them to meet at least quarterly to identify risks to financial stabiltiy, including identifying gaps in regulation.  They must annually report to Congress on what they have found.  Now, you can lead a horse to water but you can't make it drink.  When things are booming and a laissez-faire mood reigns supreme, those meetings and reports may well do no good.  But it at least forces regulators and Congress to regularly think about these issues, and provides a forum for any regulator or member of Congress who is not asleep at the switch to raise concerns. 

Second, there's an interesting new body, the Office of Financial Research (Title I, Subtitle B).  Within this is a Research and Analysis Center.  These are charged with monitoring risk and regulation and reporting annually to Congress, as well as to the Council.  With an ambitious and energetic Director and staff, that Office could take leadership in asking probing questions about what emerging risks loom for the financial system.  Indeed, if the Director wants to make a name for herself, that seems the route to go--which is just the kind of incentive we want someone within the agencies to have.

I don't mean to be Pollyannish about this.  The Act almost certainly doesn't anticipate what's likely to go really wrong next time, and the regulators probably won't either.  Indeed, that's pretty well true by definition--if they did anticipate it, after all, they would presumably act to stop it.  But I do think there's some hope that under this structure the regulators will be pushed to identify at least some important risks and work to stop them, so that maybe the next big crisis will come in 25 or 30 years rather than 5 or 10 years.  If we're lucky.

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