the dodd frank financial reform act why we need it will it work

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Financial Reform: Why We Need It, and Why it Might

Not WorkPost prepared July 17, 2010

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Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

The Dodd-Frank Financial Reform Act

Main provisions of the Dodd-Frank financial reform act:

Sets up new Financial Stability Oversight Council to indentify and act on systemic risk

Creates new authority to wind up complex financial firms that are at risk of failure

Sets up new consumer protection agency Moves trading of many derivatives to organized

exchanges for greater safety and transparency Limits proprietary trading by banks and

ownership of hedge funds

Photo source: http://www.house.gov/frank/photos/index.html


Why We Need Bank Regulation

Regulation of banking is justified by the notion that bank managers have inherent incentives to take risks greater than those justified by the public interest

The contagion effect: Failure of even one bank can cause runs on other banks and harm the non-financial economy

Moral hazard: If banks or their creditors believe they will be rescued when in danger of failing, they may not take needed precautions

Agency problems: Bank managers should act in the interests of shareholders, but bonuses, golden parachutes, and other incentives may lead them to take risks that are excessive from shareholders’ point of view

Bank Run at Northern Rock, UK, 2007Photo source: http://www.house.gov/frank/photos/index.html


Why It Might Not Work as Well as is Hoped

At 2,319 pages, Dodd-Frank is very complex, at a time when simplification is needed. Complexity invites a search for loopholes

Some important institutions, especially Fannie Mae and Freddie Mac, are not covered

The act puts off important choices on the amount of capital and liquidity required for banks

The act regulates many specific kinds of risks but does not curb the overall appetite for risk among financial institutions or deal effectively with compensation and incentive issues

Photo source: http://commons.wikimedia.org/wiki/File:Lehman_Brothers_Times_Square_by_David_Shankbone.jpg

The remaining slides analyze the Dodd-Frank Act and its possible effects using a modified version of the production possibility frontier and indifference curves


The Risk-Return Tradeoff

The tradeoff between risk and return for a bank can be represented as a frontier similar to a production possibility frontier

A movement from A to B along the frontier increases return at the cost of greater risk

Points like C, inside the frontier, show inefficient management of risk-return opportunities

Points like D, outside the frontier, cannot be reached under given market and regulatory constraints


Risk-Return Preferences

Management preferences for risk vs. return can be represented as a set of indifference curves

The curves have a positive slope because return is a “good” but risk is a “bad”

All points on any given curve are equally preferred

Movement down and to the right is toward more preferred points


Management’s Optimal Risk-Return Tradeoff

The position of the risk-return frontier is determined by market conditions and regulations

Management selects point A on a given risk-return frontier that gives the most preferred risk-return combination


Regulator’s Risk-Return Preferences

Because regulators are concerned with contagion, moral hazard, and agency problems, they tend to prefer less risk, as shown by the blue preference curves

Regulator’s preferred optimum is at point B (less risk, less return)


Desired Outcome of Regulation

Regulators would like to move the financial system along the frontier from point A to point B

Better tools to identify systemic risks might help them do this

Powers to take over management of banks facing danger of failure might also work

A third approach would be to reduce managers’ appetite for risk by reducing agency problems and moral hazard, so that they would choose outcome B voluntarily


Possible Unintended Consequences of Regulation

Rather than changing management preferences or strategies, new regulations that prohibit specific risky activities like proprietary trading, derivatives, etc. may instead change the shape of the risk-return frontier

If preferences are unchanged, management may adapt to the new regulations by choosing a point like C on the new risk-return frontier

The unintended consequence: point C is worse than the starting point for both management and regulators


The Bottom Line

Because of contagion, moral hazard, and agency problems, financial managers prefer more risk than regulators would like

Regulatory changes that deal directly with these problems can reduce management appetite for risk and lead to a better outcome

Prohibition of specific risky strategies while leaving risk preferences unchanged may lead to unintended outcomes that are worse from the point of view both of management and regulators

Most likely to improve outcomes Better resolution mechanisms to reduce

moral hazard (found in Dodd-Frank Act) Better oversight to spot and fix early signs

of systemic risk (found in Dodd-Frank Act) Improvements to corporate governance

and compensation rules to reduce agency problems (not much in Dodd-Frank Act)

Least likely to improve outcomes Dodd-Frank restrictions on specific

activities like use of derivatives, proprietary trading, and ownership of hedge funds

New authority to restrict specific lending practices in the name of consumer protection

the dodd frank financial reform act why we need it will it work

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