Revisiting Dodd-Frank; Its Design May Make Next Crisis Even Worse

This article previously appeared on the website of the Mercatus Center at George Mason University and is republished here with permission.

Problem

Drafted and enacted in response to the 2007–2009 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) became law in 2010. Dodd-Frank’s drafters hoped the law would repair the flaws in the financial system that had so painfully manifested themselves during the financial crisis. Rather than addressing the regulatory failures that led to the crisis, Dodd-Frank’s core solution was to shift decision-making from the private sector to regulators—the same regulators whose lapses had contributed to the crisis. Dodd-Frank has been costly in the short term, as any major regulatory overhaul would be. The financial industry and regulators have poured countless hours and dollars into implementing the new law. Of greater concern than these short-term implementation costs are Dodd-Frank’s potential long-run costs. Rather than averting crises, Dodd-Frank’s rejiggering of the financial system has created the preconditions for a future crisis, while inhibiting economic growth and dynamism.

Solution

Reinstituting precrisis financial regulation is not the answer. The precrisis financial regulatory system was broken, but Dodd-Frank is not the proper repair kit. The current rationale for financial regulation is misguided. A piece-by-piece assessment of Dodd-Frank to see what should be repealed is important, but it is not enough. To be effective, financial regulation also needs a perspective shift—a shift away from the current regulator-centric approach to a regulatory system that is grounded in the superior ability and incentives of market participants to collect, process, and act on information. An effective regulatory system punishes fraud, holds the institutions and people who take risks responsible for any resulting losses, avoids nonregulatory social objectives, forecloses bailout opportunities, embraces creative destruction, presumptively fosters innovation, and removes roadblocks to competition in the financial system. 

Explanation

Dodd-Frank is a sprawling law, many pieces of which are unrelated to any financial crisis—past or future. What unifies the disparate pieces is an unquestioning faith in regulatory omniscience and broad grants of power to these infallible regulators. The law calls on regulators to step in where the rest of us—individuals, firms, and nongovernmental institutions—are supposedly destined to fail, namely, to identify and address all systemic and a wide array of nonsystemic risks. In giving such heavy responsibilities to regulators, Dodd-Frank’s drafters overlooked the fact that precrisis regulators missed risks and that precrisis regulatory design contributed to the buildup of risk. By giving regulators an outsized role, Dodd-Frank suppresses the market’s intrinsic disciplining mechanisms and builds bailout expectations. Revisiting Dodd-Frank thus requires a marked change in perspective—a shift away from the comforting but ineffective “entrust the financial system to the skilled hands of the all-knowing regulators” approach to financial regulation, as well as a piece-by-piece substantive overhaul. 

Shifting the Regulatory Perspective

Dodd-Frank favors regulatory discretion over market-based regulation. It empowers regulators to use their discretion to make risk-management decisions for companies and individuals, who would otherwise respond to direction from their shareholders, customers, and creditors. Dodd-Frank not only embraces more prescriptive microprudential regulation for individual financial institutions, but it also adds another regulatory layer designed to target ill-defined and elusive “systemic risk.” This so-called macroprudential regulation allows government lawyers and economists to overrule a financial institution’s decisions—even if those decisions are legal and appropriate for the individual firm—for fear that they might endanger the broader financial system.

Financial regulators thus become central planners charged with carefully balancing the interests and risk-taking of all market participants, ensuring that firms do not fail, keeping the financial system functioning smoothly, and managing firms’ relationships with one another. This form of regulation turns regulators into allocators of credit: regulators decide who gets financed and who does not, which, in turn, affects how the economy develops, which consumer and business needs are met, and where innovation occurs. 

Regulators, driven by an evolving understanding of the inscrutable “systemic risk,” override the clear market signals through which consumers and Main Street businesses communicate their needs to financial service providers. Macroprudential regulation also displaces the market mechanisms that signal impending trouble at a financial company or in a financial sector. Regulators, who rely on imperfect, delayed information, try to foresee and forestall problems. The customers, shareholders, and creditors, who have access to more immediate information and would otherwise be monitoring the firms with which they interact, instead get the message not to worry. Regulators’ very public and costly efforts at managing the financial system and keeping risk-taking in check blunt market discipline and train market participants to look to the government for solutions. With deposit insurance and assurances of federal oversight in place, how often do you check your bank’s balance sheet? When the next financial crisis comes, the calls for government bailouts will be even louder than they were in the last crisis. 

The next crisis is likely to be worse than the last because Dodd-Frank concentrates so much power in the hands of a few regulators. If these powerful regulators make mistakes, exercise poor judgment, or miss a key market development (all of which are inevitable because they are human), the consequences will be far-reaching. Every firm that has reordered its business to satisfy a regulatory directive will find itself in trouble if that directive proves unsound. And once a crisis happens, widely applicable regulatory mandates, such as liquidity rules, could intensify it. By contrast, if firms and individuals retain decision-making authority, their errors will be contained and firms will not walk in lockstep with one another. 

That the framers of Dodd-Frank embraced enhanced regulatory authority and discretion as the answer in the heat of the crisis is perhaps understandable. The crisis hurt many people, and policymakers wanted to prevent similar harm in the future. In the years since the crisis, however, research has shown that regulatory errors lay at the heart of the crisis. Regulatory decisions drove firms and individuals to make poor choices that they otherwise would not have made. For example, Stephen Matteo Miller has demonstrated that regulation created a demand by financial institutions for mortgage-related, structured products by classifying them as safer than the underlying mortgages. Arnold Kling and Russell Roberts likewise point to the government’s inadvertent contributions to the financial crisis through misguided regulatory and housing policies. Lawrence White has highlighted the role that credit rating agency regulation—which forced firms to rely on government-credentialed credit rating agencies and kept competitors out—played in the crisis. 

Read the full whitepaper Revisiting Dodd-Frank, Mercatus Policy Primer, here.