Can Dodd-Frank Prevent the Next Financial Crisis?

Zhao Zhai, MPP, Staff Writer, Brief Policy Perspectives

In the wake of the 2008 financial crisis, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) into law. Dodd-Frank, which was named after its two sponsors, Senator Chris Dodd and Congressman Barney Frank, was crafted in response to the crisis and framed as a law that could prevent future financial market collapses. However, some critics argue that the act is not sufficient to prevent next financial crisis because it concentrates too much on regulatory failure as the cause of the crisis while downplaying other potential causes.

Background on the 2008 Financial Crisis

In 2007, a collapse of the American subprime mortgage market initiated a systemic economic crisis. The S&P 500 index dropped 57% from October 2007 to March 2009. Most banks and insurance companies suffered a liquidity crises due to their huge investments in mortgage loans. Bear Stearns collapsed and was sold at fire sale prices; the Federal Reserve helped JP Morgan Chase purchase the firm at a mere $10 per share. Later that year, Lehman Brothers became the first large investment bank to declare bankruptcy on September 15, 2008.

Many regulators and politicians claimed that lack of regulatory oversight was the primary cause of the financial crisis. In a set of 2009 remarks after  meeting at the White House with then Treasury Secretary Timothy Geithner, President Obama said.

“This financial crisis was not inevitable. It happened when Wall Street wrongly presumed markets would continuously rise, and traded in complex financial products without fully evaluating their risks. Here in Washington, our regulations lagged behind changes in our markets — and too often, regulators failed to use the authority that they had to protect consumers, markets and the economy.”

Furthermore, IMF economist Ross Levine blamed the crisis on “a systemic failure of financial regulation.” Financial institutions bought and sold risky mortgages. Investment banks, such as Lehman Brothers, bundled home loans together into mortgage-backed securities and sold slices of these bundles to investors. In order to sell more loans, they lowered credit criteria and took more risks by offering sub-prime mortgages.  Banks bought a large amount of credit default swaps from insurance companies to hedge their risk. The financial institutions saw this as a safe bet because, when mortgages default, insurance companies will compensate the credit default swap buyers and pay for default losses. They could then expand mortgage excessively and insurance companies could make hundreds of millions in fees. With one small economic shock, millions of sub-prime mortgage holders defaulted. Bear Stearns, Lehman Brothers, AIG, and nearly all financial institutions suffered tremendous losses and were at high risk of slipping into bankruptcy.

In response, the US federal government bailed out several financial institutions and created new monetary and fiscal policies. In order to prevent the crisis from becoming even more dire, the government  bailed out AIG for $180 billion, and Bank of America and CitiGroup for $20 billion.  The government deemed these rescue plans necessary because these financial institutions were “too big to fail”. In other words, if they failed, the whole financial system would be endangered.

Overview of Dodd-Frank

Dodd-Frank contains hundreds of pages of rules and regulations that stretch across dozens of federal agencies. Needless to say, it’s extremely complicated. The act’s intentions are to decrease systemic risks in the U.S financial system as well as protect consumer and taxpayer interests by providing rigorous financial oversight. Three fundamental elements help make the law work.

First, the act prohibits the Federal Reserve from bailing out nonbank financial institutions, so Wall Street firms would know that the federal government will not use taxpayers’ money to pay their gambling losses.

Second, the Consumer Financial Protection Bureau (CFPB) was created to oversee mortgage markets and prevent mortgage brokers from engaging in unfair and deceptive mortgage lending practices.  This would protect investor’s money and would prevent mortgage brokers from selling mortgage loans to consumers who do not have the ability to repay them.  The theory was that this oversight would create greater investor confidence in the financial system – making it healthier and less vulnerable to routine economic shocks.

Third, the Volcker rule, an essential part of Dodd-Frank, aimed to restrict banks from speculative and proprietary trading. As a result, conflicts of interest between banks and depositors could be reduced. Banks could become more honest, trustworthy and cautious on cash management rather than take risky investments at the expense of their customers.

Dodd-Frank’s Shortcomings

Despite these elements, critics fear that Dodd-Frank may fall short of preventing another financial crisis because of its narrow focus on a lack of financial regulation alone as the primary cause of the crisis. Because there is still disagreement over what the real causes of the crisis were, Dodd-Frank may not go far enough in preventing the next crisis. Many economists have studied different theories about how financial crises develop and how they could be prevented. There is little consensus among them. Yet Dodd-Frank acted as if inadequate financial regulation was the primary cause of the whole thing.

There are at least three major theories explaining how financial crises develop. First, some suggest a broken financial regulatory systems cause crises. This is the theory Dodd-Frank is based on.  Unbeknownst to average investors and bank customers, financial institutions leveraged this complexity and lack of oversight to take excessive risk. While these risks led to higher profits for the institutions, they gradually made the whole system unstable.

Others believe crises are caused when bubbles form and burst – like the housing or dotcom bubbles.  In the case of the housing bubble, investors could not accurately predict the fundamental value of assets, so they rushed to the real estate market and borrowed excessively. The severe mismatch between asset price and its fundamental value caused the credit default swap bubble of the 2008 financial crisis.

Other theories, mainly from the Marxist school of economic thought, state that economic fluctuation is inevitable due to  the tendency for the rate of profit to fall. Compared to bursting bubbles, declining profit could be the more dominant force lead to financial crisis. An abundance of goods leads to a decrease in their prices and profits. Return on investment constantly shrinks, preventing businesses from operating successfully.  As a result, the 2008 crisis and other crises could be merely small parts of the natural economic cycle.

Dodd-Frank’s focus on regulating markets may fall short of addressing the other possible causes of financial crises. If the next crisis is caused not by regulatory failure but by other market forces, it is not clear how effective Dodd-Frank’s regulatory regime will be.

The Next Steps

While Dodd-Frank made significant headway into regulating financial markets, concerns remain whether it can prevent the next major crisis if the causes were something other than a regulatory failure.  Disagreement remains among economists and financial experts over what the final causes of the last crisis were, and as a result, regulators should remain only cautiously optimistic. A regulatory structure alone may not be sufficient to deal with all the uncertainties in complicated financial markets. As policymaker move forward in developing new fiscal policies, they should remain open understanding alternative causes of financial crises – and consider that regulation alone might not be the best answer.

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