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House Financial Services Committee Chairman Spencer Bachus (R-AL) (C) lifts copies of the Dodd-Frank financial reform bill, September 8, 2011 in Washington, DC. (Chip Somodevilla/Getty Images)

Dodd-Frank Turns 4!

Irwin M. Stelzer

Celebrating a fourth birthday and growing nicely. That’s the story of the Dodd-Frank law, designed to end a “too big to fail” banking system that forced taxpayers to bail out bankers who took not only their own banks but the entire financial system to the verge of collapse, and brought on a record recession. Dodd-Frank, which weighed in at over 2,000 pages at birth, has since put on 14,000 pages of implementing regulations, with more to come. Lawyers here in Washington, as always the big winners when the politicians decide to fix something, estimate that the delicious regulation-writing is only half done, and that it will be five-to-ten years before all the required 400+ rules are in place. Enough fees to fund the college education of their children and, with luck, their grandchildren.

Still to come are rules requiring greater transparency for complicated transactions, and tougher rules to govern the credit rating agencies that splashed AAA ratings on duff securities, and still earn their fees from issuers only if their ratings are high enough to allow the transactions to proceed. The SEC has already notified S&P that it might face fraud charges in connection with some of the credit ratings it issued in 2011.

By which time dozens of amendments will have been added to the existing statute. Some 80 percent of the voters polled by Lake Research Partners say tighter regulation of Wall Street is needed. No surprise that President Obama, for whom bankers are his favorite whipping boy — or a close second to Republicans — used the occasion of a recent radio interview to call for additional measures to reduce risk-taking by financial institutions. Republican senator John McCain joined with Democrat Elizabeth Warren, the current darling of the White House and the party’s left, to go further: hey introduced legislation to completely separate risk-taking investment banking from plain vanilla deposit-taking. The so-called Volcker rule, which prevents banks from making risky bets with their own capital, will not go into effect until next year, at which time we will find out whether it accomplishes by rule what McCain-Warren aims to achieve by breaking up the banks into separate risky and non-risky institutions.

Regulatory cost is not the only problem Dodd-Frank has created. The regulatory maze awaits banks with assets of more than $50 billion. So banks approaching that size have an incentive to cut back on lending, since the borrowers’ IOUs are assets for the bank. Such credit squeezes by “small” banks hurt their small- and medium-size business customers, the very ones being counted on to grow and create the jobs that might turn the feeble recovery into a robust one, and relieve Fed chairwoman Janet Yellen of any guilt she might feel at tightening monetary policy.

Fortunately, Dodd-Frank seems to have accomplished more than to provide a flow of legal fees.

  • The “stress tests” to which banks must submit periodically encourage more sensible management of risk.
  • Banks now have “living wills” that lay out liquidation procedures aimed at forcing share- and bond-holders to bear all of the losses should a bank fail; taxpayers presumably will not be called on again to bail out a failed bank.
  • Dodd-Frank has forced banks to shore up their capital bases, at the expense of their profits.
  • By requiring banks to back riskier assets with greater amounts of capital, the law has forced many of them to withdraw, at least in part, from the businesses that placed their customers’ funds at the greatest risk and put taxpayers on the hook should a bank fail. Which might make the Volcker rule less important when it finally comes into force.
  • Firms that sell securities backed by bundles of mortgages now must keep some skin in the game, to use Wall Street (or is it Las Vegas?) jargon for retaining an interest in those securities.
  • Rules issued late this week by the SEC might just prevent the sort of run on money funds that contributed to the Lehman-triggered panic.

As always with these sorts of rules, there are exceptions, “loopholes” inserted by well-connected lobbyists, but we can’t let the perfect be the enemy of the good.

Once the banks have completed payment of fines for alleged past indiscretions, their profits should prove satisfactory, given the lower level of risk to which their capital is now exposed. Loan losses in the second quarter of this year were at their lowest level in eight years, down to 0.6 percent of total loans from 3.32 percent at the peak of the credit crisis. Dodd-Frank fans credit the reform statute, others say that the economic recovery has quite naturally reduced the rate of unrepaid loans.

Perhaps the most significant outstanding issue relates to the law’s requirement that a panel of regulators, the Financial Stability Oversight Council, designate some nonbank financial institutions “systemically important” and therefore in need of regulation. A lobbying scramble to avoid such a designation is underway.

It is certainly arguable that despite its heavy-handed reliance on excessively bureaucratic regulatory procedures, Dodd-Frank has reduced the systemic risk to which the banking system exposes the economy. But it is unduly optimistic to believe, to borrow from Winston Churchill, that we have ascended to the broad sunlit plains of an economy in which financial upheavals are a thing of the past. There will always be times of excessive exuberance, especially since a combination of deficient memories and greed is an unalterable characteristic of the sorts of people attracted to the financial sector. There is only one way to end “too big to fail” — eliminate “too big.”

That is not going to happen. For one thing, the big banks are not without political power, the result of the generous contributions of their executives to the political campaigns of both parties. For another, it is not at all clear that the current thrust of regulatory policy, extensive as it is, is aimed at the right problem, the size of banks.

Recall that the immediate trigger of the near-collapse of the entire international financial system was the failure of Lehman Brothers, which was not a large firm by the standards of Wall Street. That failure threatened mayhem not because Lehman was “too big,” but because it was so interconnected with other financial institutions, in ways and to an extent that regulators did not understand. We learned too late that Lehman was too interconnected to be allowed to fail, and that the laws here and in the UK might not permit such intervention.

So the important question is whether Dodd-Frank can isolate the impact not only of banks and other institutions that are too big to fail, but those that are smaller but so interconnected that they, too, would bring down the financial system if they went under. Perhaps the next 14,000 pages of regulations will solve that problem.

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