Regulating Wall Street: The Dodd-Frank Act

By Richardson, Matthew | Economic Perspectives, Fall 2012 | Go to article overview

Regulating Wall Street: The Dodd-Frank Act


Richardson, Matthew, Economic Perspectives


In this article, I review some of the main findings described in Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, which I co-edited. (1) As such, this article is based on the work of 40 or so faculty members and PhD students at New York University's Stem School of Business (NYU Stem); I especially draw on the work in the volume of my co-editors, Viral V. Acharya, Thomas Cooley, and Ingo Walter. Moreover, in this article, where appropriate, I also mention and describe some of the updates to the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act being performed by the various government agencies since passage of the act.

Because the financial crisis of 2007-09 started with a "bubble" in housing prices and was global in nature, the first narrative from analysts and academics focused on the low interest rate policy of the Federal Reserve in the years preceding the crisis and the global imbalance of payments due to the growth of emerging economies (see, for example, Taylor, 2009; Caballero and Krishnamurthy, 2009; and Portes, 2009). While these factors may have played a role in the formation of the crisis, it is generally understood that these factors were not the entire story. Rather, when analysts and academics peeled back the financial architecture of the United States and that of the global system, especially in Europe, they found gaping holes and noted that considerable parts of the architecture were broken (see, for example, Acharya and Richardson, 2009).

So, with the financial architecture in need of much improvement, the Dodd-Frank Act attempts to make the appropriate updates and repairs. Indeed, the Dodd-Frank Act reaches far and wide: In particular, the act consists of 849 pages, 16 titles, and 225 new rules across 11 agencies. (2) No one can accuse the act of not being all-encompassing. The fact the act is written this way, however, is not without some justification.

That said, one can also argue it is not well thought out in this regard. In a now infamous exchange between Federal Reserve Chairman Ben Bemanke and JPMorgan Chase CEO Jamie Dimon on June 7, 2011, the latter described a litany of changes to the financial system and asked whether any policymakers or regulators had studied the accumulated costs of such a buildup in financial regulations. Bernanke replied that there were many things wrong with the financial system, so many of these changes were needed; however, he did admit that no such analysis of the aggregate costs had been performed. (3)

Let me consider just one example of many to illustrate this point. One of the widely accepted fault lines of the financial crisis of 2007-09 was the poor quality of loans, especially nonprime residential mortgages. How does the Dodd-Frank Act deal with this issue? Here lies the problem.

First, the act sets up the Consumer Finance Protection Bureau in title X to deal with misleading products and, more generally, predatory lending practices (see also title XIV, subtitles A and C). Second, in title XIV, subtitle B and title IX, subtitle D, the act imposes particular underwriting standards for residential mortgages and focuses on the residential mortgage market, creating preferential treatment for a new brand of mortgages, notably qualified residential mortgages. Third, in title IX, subtitle D, the act requires firms performing securitization to retain at least 5 percent of the credit risk, the motivation being that these firms had no "skin in the game." Fourth, in title IX, subtitle C, the act increases regulation of the rating agencies--with a focus on their underlying conflicts of interests with issuers of asset-backed securities, as well as on the reduction of regulatory reliance on their ratings--in an attempt to increase the transparency of the credit risk of the underlying pool of loans. Yet, with all of these new provisions, the act does not even address what we at NYU Stern consider to be a primary fault for the poor quality of loans--namely, the mispriced government guarantees in the system that led to price distortions and an excessive buildup of leverage and risky credit.

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