financial stability in a complex ecology

The seemingly impossible has happened! Congress has just passed massive financial reform legislation. The scale of reform introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is now certain to be signed into law, is literally monumental. Dodd-Frank contains by far the most sweeping set of reforms to financial activity that we have seen in the 77 years since enactment of the Depression-era Glass-Steagall Act–and this is saying something for a field of legislative activity that has spawned many major statutes over the years.

Dodd-Frank has been derided by the majority of Republicans for favoring large banks and not ending bailouts, and it has been attacked on the left–Senator Russ Feingold, for example, has refused to vote for the legislation because in his view it does not go far enough. Almost every component of the 2037-page statute has generated controversy, yet hundreds of rulemaking procedures, still to be developed, will continue to add new contours and dimensions to the law. Furthermore, a lot will depend on the energy, leadership and fortitude of the Federal Reserve, the still-to-be-appointed head of the new Consumer Financial Protection Bureau, the also-still-to-be-appointed Comptroller of the Currency who will head a newly combined agency overseeing all national or federally chartered depository institutions, the SEC with its greatly extended responsibilities, the CFTC whose powers have been dramatically increased as a result of derivatives reform, and the entirely new Financial Stability Oversight Council that is meant to detect and respond to growing threats to financial stability. It is utterly impossible in one blog to name, let alone describe, all the categories of reform and areas in which financial services will never be the same again. For this post I want to focus on how long term financial stability is likely to be affected as Dodd-Frank shapes the markets.

Many have criticized Dodd-Frank for its gigantic size and for the cascades of new regulation it will trigger. The objection concerning length and bureaucracy, taken by itself, is rather naïve: the modern financial services industry, not to mention the global financial markets, is vast and complex. Any serious effort to impose structural and functional changes would inevitably be an extremely difficult, nuanced and technical matter. But the very complexity, fluidity, volatility and lability of these markets produces a complex ecology in which there can be no simple rules. Nor can we avoid regulatory discretion and simple structural solutions. And, like King Canute, we can’t command the tides to stop. Instead, regulatory responses will have to be agile and continuously adaptive. This is a tall–some might think impossible–order for any regulatory system.

In one respect, however, the financial ecology could have been made safer and more manageable. Limits should have been placed on the absolute size of the denizens of this ecology. In my view this is a major deficiency of Dodd-Frank. Efforts to impose these limits were made first by Senator Bernie Sanders and later by Senators Sherrod Brown and Ted Kaufmann but their amendments, which would have placed limits on the overall size any one financial institution could reach, met with opposition from both the large banks and the Treasury Department and either made no progress at all or were voted down during the Senate proceedings. Ironically, it appears that the new, more conservative coalition in Britain is going to try to address the question of size more courageously.

By not imposing scale limits we have left the financial system very vulnerable to continued instability, slower growth and lessened competition. The collapse of any one of the giant behemoths that roam the planet (many of which have total assets well over $2 trillion each) would bring down many other financial institutions or, far more likely, would necessitate a continuation of taxpayer bailouts under a Too Big To Fail policy that, despite official rhetoric to the contrary has not been and cannot be eliminated. The public support inevitably drawn by such institutions has been estimated by a senior regulator at the Bank of England actually to impede global recovery. And the unfair access to funds that such institutions have imposes unfair and ultimately destructive competition on smaller financial institutions. In short, we are continuing to permit an unstable financial ecology in which certain of its inhabitants threaten to stifle the healthy evolution of the ecology as a whole while placing us all at risk for sudden major collapses and crises.

It is true that the Kanjorski Amendment, which was inserted into the legislation in the House of Representatives, has miraculously survived and could, perhaps, be welcomed as something better than nothing. This set of provisions gives regulators the power to restrict or even break up financial institutions that threaten financial stability. But it seems unlikely, particularly if Congress could not summon the fortitude to do so, that the regulators will take such action quickly enough once it becomes necessary. Not only is it unlikely that regulators will stand up to the power of ultra-large institutions; it is also the case that when the circumstances demanding the break up of a financial behemoth arise the regulators are less, not more, likely to do so. The reason is what one might call an “intervention paradox:” precisely because so many other institutions will be affected, regulators tend to bet on the possibility of recovery (however unlikely such recovery might be) by keeping large ailing institutions open. To expect otherwise is to place enormous faith in a regulatory system that has failed to save us from such financial Tsunamis in the past.

Supporters have made much of the fact that Dodd-Frank makes it more difficult than before for the Fed to provide emergency lending or the FDIC to keep failing institutions open. But these provisions contain exceptions that describe exactly the problem: when financial stability is under serious threat the regulators can be permitted to take action to prevent failures. The approval processes are now much tougher, but we can be certain that they will be invoked successfully when the next crisis occurs. And inevitable though such crises probably are, they will be made all the more devastating by the size of the collapses that occur.

So even though there is much to be praised (and criticized) as far as the impact Dodd-Frank will have on routine ordinary market operations, in a curious way 2037 pages of legislation will not make us safer when things get really bad.

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