Dodd-Frank fails to meet test of our times

The US regulatory agencies will in the coming months be bedevilled by unanticipated adverse outcomes as they translate the Dodd-Frank Act’s broad set of principles into a couple of hundred detailed regulations. The act’s underlying premise is that much of what occurred in the market place leading up to the Lehman Brothers bankruptcy was excess (hardly controversial) and that its causes would be readily addressed by this wide-ranging statute (questionable).

The financial system on which Dodd-Frank is being imposed is far more complex than the lawmakers, and even most regulators, apparently contemplate. We will almost certainly end up with a number of regulatory inconsistencies whose consequences cannot be readily anticipated. Early returns on the restructuring do not bode well.

● Shortly after the act’s passage in July 2010, Ford Motor Credit pulled its plans to issue a reported billion-dollar asset-backed security. It required a credit rating, which Ford could not obtain. One of the law’s provisions had made credit-rating organisations legally liable for their opinions about risks. To ensure the issuance of the ABS, the Securities and Exchange Commission in effect suspended the need for a credit rating.

● In December, the Federal Reserve, as required by the act, in a preliminary finding, proposed to reduce banks’ share of debit card fees associated with retail transactions, leading many lenders to contend they would no longer be able to afford to issue debit cards.

● More recently, concerns are growing that without immediate exemption from Dodd-Frank, a significant proportion of the foreign exchange derivatives market would leave the US. (The US Treasury is pondering an exemption but some bank regulators insist the statute be implemented as it is.)

● Many of the act’s rules on proprietary trading, for example, apply to US banks globally. But competing US offices of foreign institutions can readily switch proprietary transactions to European and Asian banks, and if time zones are relevant, to Canadian banks.

● The act’s most surprising failure to rein in supposed market-determined excess may be its stance towards the outsized (to some, egregious) bankers’ pay packages. Small differences in the skill level of senior bankers tend to translate into large differences in the bank’s bottom line. Competition for even the slightly more skilled is accordingly fierce. Senior bankers operate as largely independent entities whose “clients” are more theirs than the banks’; they leave with the “star” when he or she changes organisation. It is doubtful that legislation can work in such an arena.

These “tips of the iceberg” suggest a broader concern about the act: that it fails to capture the degree of global interconnectedness of recent decades which has not been substantially altered by the crisis of 2008. The act may create the largest regulatory-induced market distortion since America’s ill-fated imposition of wage and price controls in 1971.

In pressing forward, the regulators are being entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are importantly altered. No one has such skills. Regulators were caught “flat-footed” by a breakdown we had erroneously thought was more than adequately reserved against. The Federal Deposit Insurance Corporation, for example, had noted as recently as the summer of 2006 that “more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards”. Even the International Monetary Fund, in April 2007, had determined that global economic risks had declined in the previous six months.

The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems. Today’s competitive markets, whether we seek to recognise it or not, are driven by an international version of Adam Smith’s “invisible hand” that is unredeemably opaque. With notably rare exceptions (2008, for example), the global “invisible hand” has created relatively stable exchange rates, interest rates, prices, and wage rates.

In the most regulated financial markets, the overwhelming set of interactions is never visible. This is the reason that interpretation of contemporaneous financial market behaviour is subject to so wide a variety of “explanations”, especially in contrast to the physical sciences where cause and effect is much more soundly grounded.

Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago? That may not be possible if we wish to maintain today’s levels of productivity and standards of living. During the postwar years, the degree of financial complexity has appeared to grow with the rising division of labour, globalisation, and the level of technology. One measure of that complexity, the share of gross domestic product devoted to finance and insurance, has increased dramatically. In America for example, it rose from 2.4 per cent in 1947 to 7.4 per cent in 2008, and to a still larger 7.9 per cent during the severe contraction of 2009.

Increased financial shares are evident in the UK, the Netherlands, Japan, Korea, and Australia, among others. Even China has joined, its share rising from 1.6 per cent in 1981 to 5.2 per cent in 2009. Deregulation, especially in America during the 1980s, clearly accounts for part, but certainly not all, of the share rise.

The vexing question confronting regulators is whether this rising share of finance has been a necessary condition of growth in the past half century, or coincidence. In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living.

The writer is former chairman of the Federal Reserve