July 20, 2010
Dodd-Frank Forum: What's the big idea?
Posted by Renee Jones

The Dodd-Frank Act needs a theory.  The Act reads like lots of bits and pieces mashed together to address the various factors identified as contributing to the 2008 financial crisis: derivatives, sub-prime, securitization, etc.  It addresses many of the symptoms of a broken financial regulatory system but fails to restore a workable regime.  What seems to be missing from the Act is an underlying theory of the primary factors that allowed all the smaller problems that the Act addresses to materialize.

In the conventional view, the financial crisis arose because the biggest banks had become too big to fail.  A corollary is that these same firms were too big to regulate.  Their size, resources, importance to the economy and political influence meant the firms could outmaneuver most regulatory attempts to control their conduct.

Despite its breadth, the Dodd-Frank Act fails to squarely address this fundamental problem.  Banks are bigger now than ever and the Act does nothing to change that.  Furthermore, the Act's provisions must be implemented by regulators, many of whom come from the very banks they are charged with overseeing.  This gives the banks and their lobbyists many more bites at the apple to prevent the imposition of regulations they find undesirable.  Add to this, the prospect of litigation challenging controversial rules and it looks as though the banks retain the upper hand in resisting unwanted regulation.

Like the Dodd-Frank Act, Sarbanes-Oxley was an instance of Congress enacting legislation in response to an economic crisis.  Yet unlike Dodd-Frank, the Sarbanes Oxley Act seemed to reflect a grand theory of the underlying causes of the accounting scandals of 2001 and 2002.  The theory can be summarized as follows: corporations and their managers had co-opted auditors and corporate directors were too inattentive, ill-informed and ill-equipped to do anything about it.  Most of Sarbanes-Oxley's provisions address these two main problems: auditor conflicts of interest and ineffective board oversight.  Whether one thinks that Sarbanes-Oxley dealt effectively with these problems, it is fairly clear that that's what Congress set out to do. 

Because the Dodd-Frank Act lacks a central thesis about what caused the financial crisis, it is unlikely to prevent future meltdowns. But by focusing narrowly on the many symptoms of regulatory dysfunction it may well prevent the re-occurrence of those events and circumstances that led up to the 2008 collapse.



 

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