Dodd-Frank Theoretically Unplugged

Torres, David L., SAM Advanced Management Journal

Passed in 2010 to fix the causes of the 2007-09 financial crises, the so-called Dodd-Frank Act contains more than 290 new regulations--with more on the way--and will create 13 new agencies. This article dissects the "levels of action" surrounding the legislation and ongoing crafting of regulations using a theoretical framework that includes structural/ functionalism, communicative action, and progeny. Much use is made of Parsons 'AGIL model of four critical components for social system survival; adaption (working through economic dynamics), goals (accomplished through political systems), integration (working through laws, judicial decisions regarding desired/undesired behavior), and latent pattern maintenance (reflected in family, education, culture). These four concepts as applied to the actual legislative tasks illuminate the challenges confronting the full-scale implementation of this massive Act.

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The financial crisis of 2007-2009 has led to the promulgation of new regulations that target systemic risk associated with commercial and investment banking as well as consumer protection in financial products. The most massive of these, the Wall Street Reform and Consumer Protection Act of 2010 (also known as the Dodd-Frank Act) is "more than twice the length of three previous regulatory bills--the Securities Act of 1933, the Securities Exchange Act of 1934 and Sarbanes-Oxley--combined" (Boggs, Foxman, and Nahill, 2011). Massive in size as well as expected impact, the Dodd-Frank Act aims to curb "two big to fail;" reorganize the regulation of banks and financial institutions; afford better protection for investors; and, introduce new rules for the protection of consumers (Kern, 2010). Included in the bill are "more than 290 new regulations and 13 new agencies (Mader, 2011)." The Congressional Budget Office estimates that up to $2.9 trillion may be spent over the next five years, with approximately 2,600 new positions added at regulatory agencies (Boggs et al., 2011).

To accomplish its goals, Dodd-Frank will reorganize existing regulatory agencies and add new oversight bodies and committees. The most important new agencies are the Consumer Financial Protection Bureau (CFPB), the Office of Financial Research (OFR), and the Financial Stability Oversight Council (FSOC). Upcoming regulations, such as the Volcker Rule for separating commercial from investment banking, "Say in Pay" provisions for Executive Compensation, and "skin in the game" mandates for risky securities, have created much uncertainty in the marketplace. Indeed, with only a fraction of the new rules in place, financial institutions and banks must abide by those rules already in place and anticipate the remainder, with final rules rolling out in the next few months.

This paper will 1) offer a schematic view of the new organizational system put in place by the Act, 2) describe how the new configuration will address myriad problems perceived as regulations based on contributors to instability in the market, and 3) offer a theoretical view that provides insight on why crafting the Act is experiencing much turbulence as it gets closer to completion. I use a very general theoretical approach. By "general," I mean not delving into theoretical nuances and debates, but rather taking understood premises from classical theory to arrive at a suitable model for analysis of the legal, social, political, and organizational dynamics surrounding the legislation.

More specifically, this paper uses general arguments from structural functionalism, communicative action, structuration, and related theories to offer an integrative perspective on the myriad levels of action that surround the legislative process. I intend to show that, while the goals of the Act have been relatively well articulated, the crafting of regulatory rules deserves special analytical attention because social, political, legal, and economic dynamics surrounding the making of the Act lack congruence.

Dodd-Frank and the Quest to Reduce Market Risk

Dodd-Frank was a reaction to the financial crisis that peaked in 2007-2008. It attempts to do the following (Senate Committee on Banking, 2010):

* Afford greater consumer protection in financial products;

* End "Too Big to Fail";

* Identify sources of risk in the financial markets;

* Provide greater transparency and accountability for exotic instruments;

* Introduce more shareholder involvement in the area of executive compensation;

* Promulgate new rules for credit rating agencies;

* Upgrade existing regulatory agencies; and

* Enforce regulation on the books.

The foregoing list reflects symptoms of a more pervasive dysfunction in the market itself--the problem of moral hazard. Moral hazard can be defined as:

... when an entity does not take account of the full consequences and responsibility of its actions, and therefore has a tendency to act less carefully than it otherwise would, and leaving another party to hold some responsibility for the consequences of those actions, a perversion of insurance theory (Brown, 2011).

Such moral hazard operates at the organizational as well as the individual level. Some consumers relied heavily on historical returns on real estate investments, taking more risk than they could absorb given their actual liquidity. Similarly, lured by the same historical patterns, financial firms viewed the CDS (credit default swap) structure, a shadow system of insuring against risk, as an adequate safety net, leading to leveraging of equity to extreme proportions. For example, ever-riskier derivative products like CDOs (collateralized debt obligations), comprising toxic mortgage packages wrapped in AAA-rated tranches, were developed and sold world-wide. Because much of this activity was over-the-counter, it escaped the oversight capacity of regulatory agencies.

The levels to which financial products could leverage equity are remarkable. Since deregulation of the markets circa 1999, and considering gas prices alone, as much as 25% of spending at the pump may be attributable to such investing (Kelleher, 2012). During this period, Kelleher (2012) found that speculation in commodities, especially through commodity index funds, grew from approximately 30% to 70%, distorting fundamental supply and demand forces. In expert testimony to the House Natural Resources Committee, Kelleher argued that these funds affect commodities futures forward curves and showed that, whereas backwardization (flat or decreasing price curves) were more common in the period before deregulation, contango effects (rising futures price curves) were significantly more frequent after deregulation. Short-term rolling of contracts was a contributory factor, as rolling overshadowed less frequent physical market hedging (Kelleher, 2012). Such effects of speculative investment are felt, not only through direct investment in the stock market or real estate, but also at the gas pump, grocery store, and other venues where natural commodities are used.

As a reaction to the financial crisis, the federal government (plus the Federal Reserve) introduced myriad mechanisms for re-stabilizing the market, including, inter alia, quantitative easing (QE 1, 2, and 3), direct monetary support for distressed firms, lowering of interest rates, and, through Dodd-Frank, reconsidering legislation that centered on risk-taking and protection for consumers of financial products. Dodd-Frank differs from the other measures because it is meant to be a long-term solution.

The process of promulgating new rules to regain market integrity includes (1) creation of the organizational matrix that will implement new regulations, and (2) managing the process of designing the rules themselves in a manner that will target and attenuate market risk that may lead to another financial crisis. Borrowing from a carpenter's mantra, and with regard to introducing new regulations, the challenge is to "measure twice and cut once," insofar as new regulations need to effectively "fit" contemporary markets. The regulations should not fall short by allowing risk that strays too far from becoming unmanageable or hamper investment to a level that will prove to be inadequate for growth. "Measuring" investment and banking activity to fit a range of "acceptable risk" and "information symmetry" is critical.

What is almost lacking is the guiding hand of a systemic approach to the challenge of implementation. And this absence perpetuates the likelihood of conflicting or weak policy and responsiveness (Mader, 2011).

Two questions emerge: Is there a body or process in place that will allow for full disclosure of forces leading up to the financial crisis, and will this process allow for effective discussion and implementation of regulations that will effectively deal with dysfunctional aspects in the markets? Second, Will the Dodd-Frank solutions be effective in diminishing targeted moral hazard activities while still allowing leveraging of equity needed to sustain growth?

Borrowing from Miles et al. (Miles, Snow, Meyer, and Coleman, 1978), Dodd-Frank creators are confronted with the entrepreneurial problem of envisioning innovative solutions to prevent past market dysfunctions; they face the engineering problem of creating an organizational mechanism that will dynamically regulate financial markets; and, they have the administrative problem of facilitating and coordinating implementation of the new regulations. As will be seen later, the innovative design put forth by Dodd-Frank is in line with the Miles and company theses; however the design is not evident in the process of creating the bill.

From an entrepreneurial perspective, the design mandates as they stand do address symptomatic activities and …

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Publication information: Article title: Dodd-Frank Theoretically Unplugged. Contributors: Torres, David L. - Author. Journal title: SAM Advanced Management Journal. Volume: 77. Issue: 4 Publication date: Autumn 2012. Page number: 19+. © 1999 Society for the Advancement of Management. COPYRIGHT 2012 Gale Group.

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