Legal Commentary

A 2300 page bill is usually an indication of many political compromises. The Dodd-Frank financial reform bill is no exception, for it is a complex, disorderly, politically motivated, and not well thought out reaction to the financial crisis that erupted beginning with the panic of the fall of 2008. Not everything about the bill is bad-e.g., the requirement that various derivatives trade through exchanges may be a good suggestion- but the disturbing parts of the bill are far more important. I will concentrate on five major defects, including omissions.

1. The bill adds regulations and rules about many activities that had little or nothing to do with the crisis. For example, it creates a consumer financial protection bureau to be housed at the Fed that is supposed to protect consumers from fraud and other abusive financial practices. Yet it is not apparent that many consumers were victimized during the financial boom years, or that consumer behavior had anything of importance to do with the crisis. For example, consumers who took out subprime mortgages that required almost no down payments and had low interest rates were not victimized since these conditions enabled them to cheaply own houses, at least for a while. The ?victims? were the banks, and especially Fannie Mae and Freddie Mac, that were foolishly willing to hold such risky mortgages.

The bill gives the Fed authority to limit interchange or ?swipe? fees that merchants pay for each debit-card transaction, although these fees had not the slightest connection to the financial crisis. Such price controls are in general undesirable, and hardly seem to require the attention of the Federal Reserve. The bill also gives the SEC authority to empower stockholders to run their own candidates for corporate boards of directors. Corporate boards often receive some blame for the crisis-mainly unjustified in my opinion- but stockholder election of some members will not improve corporate governance, and will probably make that worse.

2. The Dodd-Frank bill gives several government agencies considerable additional discretion to try to forestall another crisis, even though they already had the authority to take many actions. The Fed could have tightened the monetary base and interest rates as the crisis was developing, but chose not to do so. The SEC and various Federal Reserve banks-especially the New York Fed- had the authority to stop questionable lending practices and increase liquidity requirements. These and other government bodies did not use their authority to try to head off the crisis partly because they got caught up in the same bubble hysteria as did banks and consumers. In addition, regulators are often ?captured? by the firms they are regulating, not necessarily because the regulators are corrupt, but because they are mainly exposed to arguments made by the banks and other groups they are regulating.

Despite the fact that regulators failed to use the powers they already had, the bill mainly adds not clear rules of behavior for banks, but additional governmental discretionary power. For example, the bill creates the Financial Stability Oversight Council, a nine-member panel drawn from the Fed, SEC, and other government agencies, that is supposed to monitor Wall Street?s largest companies and other market participants to spot and respond to any emerging growth in systemic risk in the economy. With a two-thirds vote this Council could impose higher capital requirements on lenders and place hedge funds and dealers under the Fed?s authority. Given the regulators reluctance to use the power they already had to forestall the crisis, it seems highly unlikely that this Council will act decisively prior to the emergence of a crisis, especially when a two thirds majority is required.

3. Insufficient capital relative to bank assets was an important cause of the financial crisis. The bill does reduce the ability of banks to count as bank capital certain risky assets, such as trust preferred securities, and gives the Fed authority to impose additional capital and liquidity requirements on banks and non-bank financial companies, including insurers. I would have preferred a simple rule that raised capital requirements of banks relative to their assets, especially capital of larger and more interconnected banks. As suggested by Raghu Rajan and the Squam Lake group of economists, the bill probably should have required larger banks to issue ?contingent? capital, such as debt that automatically converts to equity when the banks are experiencing large losses, or when a bank?s capital to asset ratio falls below a certain level.

4. One of the most serious omissions is that the bill essentially says nothing about Freddie Mac or Fannie Mae. In 2008 these organizations were placed into conservatorship of the Federal Housing Finance Agency. During the run up to the crisis, Barney Frank and others in Congress encouraged Freddie and Fannie to absorb most of the subprime mortgages. In 2008 they held over half of all mortgages, and almost all the subprimes. They have absorbed even a larger fraction of the relatively few mortgages written after 2008. Freddie and Fannie deserve a considerable share of the blame for the crisis, but they continue to have strong political support. I would like to see both of them eventually dissolved, but that is unlikely to happen. Instead we are promised that they will be dealt with in future legislation, but I am skeptical that anything will be done to terminate either organization, or even improve their functioning.

5. Many proposals in the bill will have highly uncertain impacts on the economy. These include, among many other provisions, the requirement that originators of mortgages and other assets retain at least 5% of the assets they originate, that many derivatives go on organized exchanges (may be an improvement but far from certain), that hedge funds become more closely regulated, and that consumer be ?protected? from their financial decisions. 

Most of these and other changes in the bill are not based on a serious analysis of what contributed to the financial crisis, but rather are the result of political and emotional reactions to the crisis. Usually, such reactions do more harm than good. That is likely to be the fate of the great majority of the provisions of the Dodd-Frank bill.