After Dodd-Frank: Be afraid, be very afraid

1213599_pillsThe U.S. regulatory response to the global financial crisis has been significant, with sweeping changes in the form of Dodd-Frank that aim to quell fears over systemic risk. So should we feel safer? And are those reforms leading to meaningful changes?

Not so much, according to some. In fact, it looks like they could be making things worse.

In fact the authors of this this new paper say Dodd-Frank and other related reforms by major regulatory authorities could actually do further harm to financial stability. In Misdiagnosis: Incomplete Cures of Financial Regulatory Failures authors James R. Barth, Gerard Caprio Jr., and Ross Levine argue that U.S. reforms have actually intensified moral hazard dramatically increased the problem of Too Big to Fail by sending a signal “that there is still a high likelihood that they will rescue large failing institutions.”

The authors also point out that Dodd-Frank still puts regulatory authorities under the sway of special interests.

“Dodd–Frank and other related reforms by major regulatory authorities may be hurting, not helping, financial stability and the efficiency of capital allocation,” they note.

What the reforms do not address, however, is a key factor leading to the crisis say the authors: the failure of regulators to act. As they write:

The perfect storm explanation of the global financial crisis is a perfect excuse for regulators: no one could have anticipated it; thus no one can be blamed. This faulty diagnosis of the crisis—the lack of attention to a central factor, regulatory inaction—paved the way for the response, namely one of an increasingly complex regulatory framework in the United States (Dodd–Frank) and industrial countries more broadly (Basel III). Indeed, one of the curious features of the crisis is that the Federal Reserve, whose regulatory inaction contributed to the crisis, nonetheless was rewarded with a larger role in safeguarding systemic stability; its loss of the consumer protection function seems to have been without any lament. And the Basel approach to bank regulation, which featured reliance either on ratings or risk models, both of which failed in the run-up to the crisis, now features more of the same, with a bit higher capital requirements and a complex liquidity rule.

To make matters worse, the authors also point out that there is little evidence that economies are better protected from these reforms.

You can read the full paper here. Meantime, do Dodd-Frank and other regulatory reforms make you feel safer? Feel free to share below.