The Shortcomings of Dodd-Frank

The reforms are four years old but have yet to be properly implemented
Illustration by Bloomberg View

Four years after President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, polls suggest most Americans think it hasn’t done enough to protect them from a repeat of the 2008 crisis, a disaster from which the global economy has yet to fully recover. They’re right.

At its core, the Dodd-Frank Act was supposed to work like a three-stage containment system. Better monitoring and limits on risk-taking would make accidents less likely. If financial institutions did get into trouble, added capital would make them more likely to survive. If they nonetheless failed, advance planning and new resolution mechanisms would allow them to do so without bringing down the financial system and the economy. Regulators have yet to complete any level of this fail-safe system.

At the first stage, the Volcker Rule prevents deposit-taking banks from engaging in the kind of speculative trading that can precipitate sudden losses, and the Federal Reserve’s stress tests help ensure that large banks are prepared for the most obvious risks. Poor global coordination and data difficulties, however, have left regulators far from their goal of creating an early warning system that could tell them where the risks are concentrated. If, for example, a big U.S. hedge fund were heavily invested in foreign banks that were about to be wiped out by losses in emerging markets, nobody would see the whole picture.

At the second stage, U.S. regulators have set capital requirements for bank holding companies at $5 for every $100 in assets, enough to absorb a 5 percent loss. That’s more than most had at the last crisis, but still much less than what’s needed. Economists at New York University estimate that the six largest U.S. banks are almost $300 billion short of the capital they’d need to survive a severe crisis. Other institutions, including money-market mutual funds, still face no capital requirements at all.

At the third stage, regulators have made much of what they call the orderly liquidation authority, which allows the Federal Deposit Insurance Corp. to swoop in, take over, and recapitalize a failing bank holding company, all while keeping its important subsidiaries running as if nothing were amiss. The mechanism, though, remains untested, and even the FDIC’s own vice chairman doubts it could handle a crisis like that of 2008. Meanwhile, regulators have so far tolerated banks’ inability to produce convincing “living wills,” in which they must show how they could be safely dismantled through the bankruptcy process.

Markets have offered their verdict on Dodd-Frank: Studies show creditors lend money more cheaply to the largest banks on the assumption the government will rescue them in an emergency. The International Monetary Fund estimated this implicit taxpayer subsidy at as much as $70 billion a year in 2011 and 2012.

Dodd-Frank provides regulators with the powers they need to prevent the financial sector from leaning on taxpayers and endangering the economy. All that’s wanting is the will to use them.

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