Have We Created Frankendodd?

Finance conference considers the implications of the sprawling Dodd-Frank law

The natural order of things is, well, orderly. There is cause, and there is effect. Lightning flashes and thunder claps. April showers bring May flowers. Financial crises bloom, and federal regulators reformulate their arsenal of economic herbicides.

"All discussions of banking reform tend to occur in the aftermath of a crisis," noted John G. Walsh, speaking at the Conference on Dodd-Frank and the Future of Finance, a two-day event held in June and sponsored by the Center for the Study of Financial Regulations at the Mendoza College of Business, University of Notre Dame. Walsh, an economist and former acting Comptroller of the Currency, joined academicians, economists and regulators at the Grand Hyatt hotel in the nation's capital to consider what Washington hath wrought with its latest attempt at a post-crisis financial fix.

Crisis as regulatory causation is well-documented. Wildcat banking during the Civil War resulted in the National Currency Act and the National Bank Act; half a century later, runs on banks gave us the Federal Reserve Act; the Great Depression resulted in creation of the Federal Deposit Insurance Corp. and the SEC; the S&L crisis of the early 1980s led to new laws regulating depository institutions; and the Enron and WorldCom bankruptcies gave birth to the Sarbanes-Oxley Act.

The net result is "more laws, more regulations, and … more regulatory authorities," said James R. Barth, the Lowder Eminent Scholar in Finance at Auburn University, a senior fellow at the Milken Institute, and a fellow at the Wharton Financial Institution Center.

Indeed, the financial crisis of 2008 spawned, in its immediate aftermath, the Federal Housing Finance Regulatory Act and the Emergency Economic Stabilization Act. Two years later, having more fully digested the enormity of the crisis, Congress disgorged the mother of all financial regulatory laws, the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010.

The sprawling law seeks to strengthen the financial system by increasing transparency, accountability and stability. It also aspires to end the government's bailout of financial institutions deemed "too big to fail." A key (and controversial) provision of the law, the Volcker Rule, prohibits banks from engaging in proprietary trading and certain activities involving hedge funds. Due to its complexity, most of the law's provisions have not yet taken effect.

Dodd-Frank also addresses issues that some observers say have little direct relevance to the crisis or its causes. "Someone likened the process that created Dodd-Frank to a barroom brawl," said the moderator of a panel on banking reform, Jim Overdahl, who is vice president in the securities and finance practice at NERA Economic Consulting and a former chief economist for the SEC. "Of course, the important thing about a barroom brawl is that you don't hit the guy who started the fight, you hit the guy you've been meaning to hit."

Craig Pirrong, a professor of finance at the Bower College of Business, University of Houston, and director for the Global Energy Management Institute, compared the law to a horror show. "I call it Frankendodd because it's basically a monster that has gotten out of control of its creators," said Pirrong, who sat on the conference's Panel on Derivatives Reform.

The complexity of Dodd-Frank mirrors uncertainty about the precise causes of the 2008 crisis, doubt that persists after three years of analysis. Hindsight, for once, is 20/80. "There is still significant disagreement as to what the underlying causes of the crisis were and even less agreement as to what to do about it, but what may be more disconcerting for most economists is the fact that we can't even agree on all the facts," said Anjan Thakor, the John E. Simon Professor of Finance at the Olin School of Business at Washington University in St. Louis. "Did CEOs take too much risk? … Was there too much leverage in the system? Did regulators do their job? Or was forbearance a significant factor?

"Was the Fed's low interest rate policy responsible for the housing bubble? Or did other factors cause housing prices to skyrocket? Was liquidity the issue with respect to runs on the repo market or was it more of a solvency issue among a handful of problem banks?"

"There's a lot of disagreement on even the basic facts," Thakor concluded.

Where there is agreement, it often coalesces around criticism of the law, said John Dearie, executive vice president for policy at the Financial Services Forum, an economic policy organization comprised of the CEOs at large financial institutions. Displeasure with the law is of four main types, said Dearie, who sat on the conference's final panel, An Overview of Dodd-Frank.

Critics say it is "absurdly long and complex," that it's "just too difficult to implement," that it is "largely silent on a number of causes of the crisis," including the role of Fannie Mae and Freddie Mac, and that it "institutionalized" problems that it should have solved, including the "too big to fail" issue, Dearie said.

That drumbeat of criticism has contributed to a "broader and deeper narrative … that nothing has really happened since the crisis," he said. "That is certainly not true. A great deal of progress

has been made since 2008." Stronger asset and balance sheets and a doubling of capital and liquidity levels since 2009 have made the banking system "far stronger and more resilient."

Dearie further suggested that requiring banks to hold higher levels of capital, while prudent, has increasingly come to be seen as something of a panacea.

"Capital in recent months has emerged as not only a centrally important issue but seemingly a silver bullet solution to virtually every supervisory challenge, whether those challenges be associated with large institutions or funding structures, wholesale deposit, et cetera," he said.

Not only are higher levels of capital subject to the law of diminishing returns, "ever higher capital can even become perverse. It can actually incentivize greater risk taking … which is certainly not the objective of the higher capital policy," Dearie said.

Sitting on the panel with Dearie were Barth, Larry White and David Skeel. White is the Robert Kavesh Professor of Economics at New York University's Leonard N. Stern School of Business. Skeel is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School and author of The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (Wiley, 2011).

Barth asserted that the financial crisis originated in the housing sector and "began to emerge more fully in the summer of 2007, spread throughout the financial system and that, in turn, led to the recession in December of 2007, which ended in the summer of 2009." But in the view of White, "too big to fail" was at the heart of the financial crisis.

A key objective of Dodd-Frank is to circumvent the government's bailout of institutions whose failure, in theory, could cripple the economy of the United States and the world. Conference attendees consistently questioned whether the law would accomplish that or other goals. "If we have another crisis, will [the government] bail them out all over again?" asked Skeel. "In my view, this doesn't end too big to fail. Not at all."

Skeel, the conference's final presenter, admitted being "sort of overwhelmed by the problems and complexities that we've talked about over the last couple of days."

"The few things we're pretty sure would work as a practical matter … are politically impossible. The things that are politically possible … it's not at all clear that they'll work."