This content is from: Culture

The Unintentional Consequences of Dodd-Frank

Two years after the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted, it may be time to rethink and simplify the regulatory rules.

Bankers can generally be expected to resist or react negatively to regulations. When confronted with 2,300 pages of new law — the Dodd-Frank Wall Street Reform and Consumer Protection Act — and the prospect of thousands more pages of regulatory rules, compounded by parallel actions in international jurisdictions, industry executives predictably went ballistic. Two years after the enactment of Dodd-Frank, the hand-wringing continues. Dozens of mandated regulations have yet to be completed, while policymakers grapple with events such as MF Global Holdings’ collapse and JPMorgan Chase & Co.’s trading fiasco. When the latter prompted calls in Washington for more-urgent adoption of the Volcker rule — the Dodd-Frank provision prohibiting certain forms of proprietary trading — industry defenders retorted that there was no certainty that a fully implemented rule would have prevented JPMorgan’s troubles. If there is still controversy over the effectiveness of such a high-profile regulatory response to a specific perceived problem, what does that imply about the overall quality of the reform effort? From some quarters the Dodd-Frank critique is even more encompassing. Richard Kovacevich, retired chairman and CEO of Wells Fargo & Co., asserted in a recent speech that if the law was meant to reduce the concentration of assets in institutions deemed too big to fail, it badly missed the mark. The more highly regulated an industry — think airlines, pharmaceuticals, telecommunications — the more likely it is to be dominated by a few big players that can more easily bear the compliance burden than can smaller, less-deep-pocketed entities. “How can you have confidence in government decision making,” Kovacevich asked at the Stanford Institute for Economic Policy Research on June 12, “when the decisions they make often have the exact opposite impact from the objective they are trying to achieve?” Kovacevich is among those who say increased bank capital, intended to protect balance sheets in future downturns, is slowing credit expansion and hence the economic recovery. U.S. over-the-counter derivatives dealers warn that too many Dodd-Frank restrictions — which they contend are more appropriate to protect individual investors than to apply to their wholesale businesses — will drive transactions onto overseas markets. No matter how big or well intentioned, any reform package will have flaws. What was lacking in Dodd-Frank was more fundamental: an understanding of limitations and history. The act was a product of politics and rushes to judgment, attacking symptoms with little regard to root causes. In his 2007 book, A Demon of Our Own Design, Richard Bookstaber, a former hedge fund risk manager who is now an adviser to the U.S. Treasury Department, described the financial system as “interactively complex” and tightly coupled; if one component fails, there is little margin for error or time to adjust. Financial markets have these characteristics in common with jet airplanes, nuclear power plants and other systems prone to “normal accidents.” “The natural reaction to market breakdown is to add layers of protection and regulation,” Bookstaber wrote. “But trying to regulate a market entangled by complexity can lead to unintended consequences, compounding crises rather than extinguishing them because the safeguards add even more complexity, which in turn feeds more failure.” The post-2008 crisis response was a layering of complexity upon complexity unprecedented only in degree. Kovacevich pointed out at Stanford that in the late 1970s and early ’90s, “we piled on more and more extensive and burdensome regulation without addressing the actual causes of the crisis or the ineffective regulatory system that allowed it to happen.” Construction of a workable, modernized regulatory framework would begin with an acceptance of the realities of the complex, tightly coupled system that the financial industry is. Prudential regulatory models designed for small or regional banks may not work. Fresh thinking is called for, and, paradoxically, it may start with simplicity: back-to-basics statements of principles and objectives, as well as an understanding of the value of risk-taking and of markets’ role in disciplining it. The regulatory mind-set needs to be agile and expansive, not rigid and prescriptive.

“There is no regulatory requirement that can capture all this complexity,” Gabriel Bernardino, chairman of the European Insurance and Occupational Pensions Authority, said in an April speech in Dublin. “This just means that we need to be pragmatic, accept a certain level of imperfection in regulation and diversify the tools used to deal with the increased complexity.”  •  •

Jeffrey Kutler is editor-in-chief of Risk Professional magazine, published by the Global Association of Risk Professionals.

Related Content