The Dodd-Frank Act versus the Rule of Law

Brief Analyses

No. 775
Tuesday, October 09, 2012
by Roger Koppl

In response to the 2008 financial collapse, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank increased regulation of banks, stockbrokers, insurers and other financial institutions that are “too big  — or interconnected — to fail” and that could require a government bailout to prevent a banking system collapse.

The Act created a board — the Financial Stability Oversight Council — composed mostly of the heads of various federal financial regulatory agencies, including some newly created agencies [see the table]. The Council has the responsibility to identify institutions whose failure might create systemic distress — and the discretion to impose “prudential” regulations on them different from the regulations imposed on other financial institutions.

Regulation is discretionary when the requirements imposed on privately owned institutions vary from firm to firm in ways that are difficult to explain or anticipate, particularly by the affected firms. In the extreme form, regulations could be imposed on specific firms,  regardless of the type of business they conduct, or whether they are chartered by individual states or the federal government.

Discretionary regulation is contrary to the rule of law, but is consistent with the “rule of men” — in this case, experts in financial regulation. However, by their very nature, discretionary regulation cannot reliably produce the results its advocates desire; furthermore, these regulations will increase financial instability, rather than reduce it.

Discretionary Regulation in Theory.Economists who support Dodd-Frank usually cite network theories that claim the financial system is inherently unstable because all its institutions are interconnected and interdependent. These network theories say that a shock in one region or sector of the economy, such as the collapse of a major bank or insurance company, can spread to the whole — a so-called contagion. Advocates of such theories believe regulators can reduce instability by constraining the investment portfolios of financial institutions in order to reduce the “domino effect” — that if one institution fails they will all fail. Some economists, including the executive director of financial stability for the Bank of England, advocate “shaping the network topology,” which comes close to saying regulators should pick portfolios for the banks.

Following the 2008 financial crisis, economist Janet Yellen recommended supervision of so-called systemic institutions, “defined by key characteristics, such as size, leverage, reliance on short-term funding, importance as sources of credit or liquidity, and interconnectedness in the financial system — not by the kinds of charters they have.”

Such regulations could vary the amount and composition of a firm’s capital (risk-based capital requirements), the ratio of its debts to its capital stock (leverage limits), and how much cash it is required to keep on hand (liquidity requirements). Yellen’s recommendations were to a great extent enacted in Dodd-Frank.

Discretionary Regulation in Practice. Discretionary regulation is not new. For example, the Sherman Antitrust Act of 1890 outlawed the unreasonable restraint of trade, a vague term that has never been satisfactorily defined. Such vagueness invites discretion in interpretation and enforcement.

Although discretionary regulation is not new, the element of discretion created by Dodd-Frank is so great that the regulators themselves seem perplexed. For example, Dodd-Frank added a new section to the Bank Holding Act (BHC) of 1956 requiring a group of regulatory agencies to formulate a Volcker rule — a proposal by former Federal Reserve Board Chairman Paul Volcker to limit proprietary trading and conflicts of interest between financial institutions and their clients. In the rule proposed in November 2011, the agencies note “the delineation of what constitutes a prohibited or permitted activity under section 13 of the BHC Act often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice.”  Thus, the very regulators empowered to execute the Act report that it is not merely hard to understand, but opaque.

By one count, Dodd-Frank calls for regulators to formulate 533 rules, all of them more or less open ended and unspecified. However, recommendations have been made regarding what such regulations should do, including:

  • Levying taxes (“fees”) on institutions in proportion to the risks they pose to the financial system.
  • Imposing higher liquidity requirements on the most connected banks in the network.
  • Establishing central clearing of financial transactions —simplifying but centralizing the network.
  • Limiting bank size or activities, and controlling the composition of bank portfolios.

The discretionary regulations called for in Dodd-Frank make it difficult for people to anticipate the legal consequences of their actions. Thus, it violates one of the principal requirements of the rule of law. As Harvard law scholar Richard H. Fallon, Jr., explains, “People must be able to understand the law and comply with it.”

Rule by Experts. The Financial Stability Oversight Council is a body of experts. Such experts are imagined to exist and operate, somehow, above the system, and uninfluenced by it. However, it is more appropriate to treat experts as ordinary humans. As humans, experts may try (perhaps in vain) to maximize utility — that is, enact their own preferences. Moreover, their cognition is limited and erring; they are not smarter than the rest of us. And, importantly, incentivesdo influence the errors the experts make.

Maximizing Utility. If experts seek to maximize utility, they may not be impartial. They could serve other ends, such as larger budgets for their agencies. Even conscientious regulators could have risk preferences different from those of the public, and as a result they might over- or under-price risk. The motives of policy makers need not be selfish to be dangerous.

Limited and Erring Cognition. Dodd-Frank gives regulators the responsibility to assess the risks to the financial system posed by financial institutions. There is no competitive market for risk assessment. Indeed, the goal is to monopolize risk assessment. But absent market signals of greater and lesser risk, authorities cannot assign reliable risk charges to the capital portfolios of different institutions. The very complexity used as a justification for centralized risk assessment may make it impossible for a central body to reliably assess risk.

Influence of Incentives. Finally, incentives skew the errors experts will tend to make, even honest errors. Indeed, all observations are biased by the expectations and motives of the observers. Regulatory errors will tend to serve the biases of the regulators. It is quite possible that collectivized risk assessment may be beset with systemic biases. Without a market to test those assessments, such biases could go uncorrected, and could grow over time.

Conclusion. By replacing competitive evaluations of risk in the marketplace with centralized risk pricing, Dodd-Frank ensures that financial institutions, investors and depositors will have less information about the risks they face. And by further displacing the rule of law with discretionary regulation, the Act ensures that there will be less certainty about the future. As a result, it increases the instability of financial institutions, rather than reducing it.

Roger Koppl is a professor of economics and finance in the Silberman College of Business and director of the Institute for Forensic Science Administration at Fairleigh Dickinson University, and a senior fellow with the National Center for Policy Analysis.