Burning Question: Will the Dodd-Frank Act avert another financial crisis?

The Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law last July was passed as a response to the financial crisis of 2008, and has been billed as the most sweeping change to financial regulation in the United States since the Great Depression. But will the Dodd-Frank Act avert another financial crisis? We asked Gensemer Professor of Economics Will Melick and his student Ellie Norton '10.

That's an easy one—most likely not. Financial crises are simply part and parcel of any economic system. But suppose we ask instead if the 2,300-page Dodd-Frank Act will either reduce the frequency of, or make for smaller, future crises. Even here we have our doubts. Fundamentally, Dodd-Frank is targeted more at preserving the pre-crisis financial order than at overhauling the financial system.

Our financial system sits on a fault line generated by human fallibility. While the system's channeling of funds from savers to borrowers is an essential element of any prosperous economy, these allocations are naturally based on forward-looking, error-prone human judgments about risk and return. History is full of examples—be it tulip bulbs in Holland, South Sea Company shares in England, or residential real estate in Las Vegas—where those judgments become overly optimistic. The result is financial panic and crisis.

We can think of our financial system in 2010 as a damaged building, post-earthquake. The Dodd-Frank Act represents the view that the foundation of the building should remain in place. It accepts the pre-crisis financial structure as sound, and implies that we just need some regulatory changes to better anticipate and better respond to the next crisis when it arrives.

This approach is the chief reason to be skeptical that the act will do much to forestall or minimize future crises. By leaving the basic configuration of the financial system unchanged, Dodd-Frank dangerously entrenches America's most powerful financial firms.

During the last crisis, it became evident that the financial "building" stands on only a few, huge pillars. Damage to just one of these pillars threatens the stability of the entire structure. Even before the crisis, the pillars—America's largest financial firms—came to be known as "Too Big to Fail." It was assumed that the government would not allow these big companies to completely collapse in the event of a crisis. Ironically, this implicit guarantee allowed the firms to borrow cheaply and, ultimately, to take greater risks.

The government made good on its unspoken promise in 2008, and now Dodd-Frank has enshrined the "Too Big to Fail" doctrine. The act requires some financial firms to be explicitly identified as "systemically important." These companies will essentially make a grand bargain with the government, accepting some restrictions on their activities in exchange for protection from competition. Thus, they are almost certain to grow even larger. And when one of them inevitably goes astray, when the next earthquake comes, the resulting crisis will be that much worse, and the building will be that much more likely to crumble.

Dodd-Frank does include mechanisms designed to reduce the likelihood of large firm failures and to lessen their impact. But these mechanisms are simply not credible. The new Financial Stability Oversight Council has the power to call for the liquidation of systemically important companies during a crisis, and to demand, crisis or no, the break-up of an institution that poses a "grave threat" to the economy. But can we trust that the council will actually be willing to break up or liquidate such a company—basically admitting that its own oversight was lax? Bank regulators, long able to shut down problematic banks, have never been able to muster the will to pull the trigger. A new council of regulators demanding the termination of a financial firm's activities during non-crisis times is neither believable nor politically viable.

Furthermore, the systemically important firms wield enormous power in Washington. Many of Dodd-Frank's broad provisions rely heavily on regulatory agency rule-making. Incumbent firms will influence this complicated, three-year process to their advantage, likely watering down any rules that are ultimately adopted. We already saw this happen as the act moved through Congress—the original conception of the Volcker Rule, designed to curb banks' proprietary trading, slowly devolved into a threshold that won't actually affect most big banks.

In short, Dodd-Frank does not call for a rebuilding of our financial system, but protects and strengthens the pre-crisis financial order. The acceptance of "Too Big to Fail" and the influence of large incumbent firms essentially guarantee that this act, like all financial reform efforts before it, will do little to prevent the next financial crisis.

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