Q: What are some of the key issues of Dodd-Frank?
DS: To very quickly put the legislation into context, people talk about the Dodd-Frank Act being an incoherent mess, 2,319 pages of chaos. But it really isn't. The legislation has two main responses to the financial crisis: first, it tries to limit the risk of the instruments (such as derivatives) and the giant banks and other "systemically important" financial institutions of contemporary finance; and second, it tries to limit the fallout in the event a systematically important financial institution nevertheless falls into financial distress. Parts of the legislation actually work pretty well. I think the derivatives regulation is likely to be effective. Lots of other parts don't work so well, and in my view will have unintended negative consequences.
Q: Such as?
DS: The legislation solidifies the status of the largest financial institutions as too big to fail. It singles the giant banks out for special treatment, but it doesn't try to limit their size or break them up — it just assumes that we're going to have these giant banks dominating our financial services industry. I fear that this will have unfortunate consequences. For example, it's going to be very difficult for small- and medium-sized banks to compete with the giant banks. As a result, I think we may see less innovation in the financial services industry than we otherwise would. We also may well have less lending to small - and - medium-sized businesses, because the small- and medium-sized banks are the ones that, historically, have lent to small- and medium-sized businesses. I also fear that the legislation could create a "partnership" between the government and the largest banks. The legislation contains a number of provisions that could be used to extract concessions from the largest banks, which creates the risk of political policy dictating banking decisions rather than just economics dictating banking decisions.
Q: And what if these giant banks fail?
DS: Well, the second set of concerns has to do with just that. Dodd-Frank's new resolution rules give regulators the power to take over one of these giant institutions if it runs into trouble. The premise of this system is that what we do with small- and medium-sized banks now is a good model for how to deal with giant institutions when they fail. In my view, this strategy - which gives bank regulators sweeping authority - makes far less sense for giant financial institutions than for small banks. I think that lawmakers should have taken a much closer look at bankruptcy, which relies less on the discretion of regulators.
Q: Why, in your view, is a market-based approach involving bankruptcy a better approach than bailouts?
DS: The danger, in my view, of a regulatory approach to the insolvency of these institutions is two-fold. First, regulators tend to not know that a collapse is coming until it's too late. Yes, Dodd-Frank is going to help by requiring more oversight and a lot more disclosure. But very frequently, the managers know there's a problem long before regulators do. So, to the extent you can encourage decision makers who do know what's going on, such as the managers of the business and its creditors, to make the decision when it's time for insolvency proceedings, as they do with bankruptcy, I think that's a good thing. The second concern I have is that there is an inevitable incentive for regulators to bail out a giant institution when there's trouble. If they don't bail out one of these institutions and it blows up, that's egg on their face. That said, I'm not saying that bankruptcy is always the best solution in these situations. Occasionally you do need to inject money into the marketplace. My claim is that whenever possible, it's better to use a more market-oriented approach like bankruptcy that assures companies aren't bailed out; and assures that creditors do, in fact, take losses if the company they've lent money to does badly. And in my view, Dodd-Frank pushes things too much in the other direction. It creates, if anything, disincentives to use bankruptcy.
Q: What do you think works about the legislation?
DS: Before Dodd-Frank, derivatives were for the most part simply unregulated. Dodd-Frank requires that most derivatives be submitted to a clearinghouse, which will be responsible for guaranteeing the performance of both sides of the derivatives contract. Dodd-Frank also requires that most derivatives be traded on exchanges, so they can no longer be secret, private deals between two banks. Now they have to be publicly disclosed and their terms will be a little bit more standardized. The Dodd-Frank innovation that I like is the new consumer financial protection bureau. Supporters of the consumer bureau argued that none of the regulators who were supposed to protect consumers were in a position to effectively champion consumers' interests. The Federal Reserve, for instance, had primary responsibility but also suffered from a serious conflict of interest. The Fed's primary mission is to preserve the stability of the banking system, which can directly conflict with protecting the interests of consumers. Sometimes gouging consumers is a way to preserve bank stability. The beauty of the consumer bureau is that it creates a new consumer champion that's not conflicted, whose primary responsibility is to focus on consumers and to make sure consumers are protected in the financial marketplace.