Academic journal article Journal of Business and Behavior Sciences

How Well Does Dodd-Frank Address Regulatory Gaps and Market Failures That Led to the Housing Bubble?

Academic journal article Journal of Business and Behavior Sciences

How Well Does Dodd-Frank Address Regulatory Gaps and Market Failures That Led to the Housing Bubble?

Article excerpt

ABSTRACT :

This study maps key provisions of the Dodd-Frank Act of 2010 against gaps in regulation and market failures that led to the housing bubble, which burst since the Spring of 2006. The creation of one systemic regulator, replacement of ratings by credit rating agencies with an internal rating system, and revision of the banks' capital requirements to address credit and market risks have the potential to remove the kind of regulatory capital arbitrage that led to excessive leverage during the housing boom, and enable early detection of threats to the financial system. However, liquidity thresholds on banks, limits on the use of short-term funding for long-term assets, and limits on investments in mortgage-backed securities that are meant to transfer risk outside of the banking system, still need to be worked out. Finally, the success of Dodd-Frank hinges on the regulatory philosophy and adequate funding of regulatory agencies.

INTRODUCTION

The subprime crisis drastically changed the financial landscape in the United States. Of the five largest investment banks, only two survived (Goldman Sachs and Morgan Stanley) by obtaining authorization from the Fed to become bank holding companies, along with large consumer finance companies (American Express and CIT). The federal government took substantial ownership stake in AIG, the world's largest insurance company, and took Fannie Mae and Freddie Mac into conservatorship. With the Fed's aggressive use of new emergency lending facilities and Congressional authorization of the Troubled Assets Relief Program, fewer banks failed during this crisis than during the S&L crises of the 1980s and the Great Depression.

By now, there is a general understanding that the housing bubble was fueled by lax underwriting of subprime mortgages and excessive leverage, and that the bursting of this bubble led to the financial crisis of 2008. The Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) signed into law by President Obama in July 2010 has been hailed as the most comprehensive reform of financial regulation in the U.S. As expected, some believe that DFA is excessive, while some are skeptical that it can prevent another financial crisis. The objectives of this paper are: (1) to map the provisions of DFA against regulatory and market failures discussed in existing literature; and (2) to evaluate how well DFA addresses these regulatory and market failures. The paper starts with a review of literature on the market failures that justify government intervention in the financial sector, as well as regulatory and market failures that caused the housing bubble. This is followed by a mapping of the provisions of DFA against these market and regulatory failures. Following an analysis, the paper closes with some concluding comments.

LITERATURE REVIEW

The need for government intervention in the finance sector of the economy and the extent of such intervention has many rationales in the economics literature. Prior to the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1934, the failure of a bank created uncertainty about which banks will fail next and resulted in bank runs, with a negative spillover effect (Pigou 1932) on the economy as a whole. Depositors panic and rush to close their accounts when they are unable to distinguish the good banks from the bad banks, a problem of asymmetric information (Ackerlof 1970) since bank insiders have better information about the soundness of the bank's financial position than its depositors. Thus, despite the reliance of the U.S. on the market system to determine the prices of goods and services, financial institutions are subject to varying degrees of government regulation. Regulation of banks in the U.S. has been relatively more intrusive than the regulation of nonbank financial institutions like broker-dealers and mutual funds. Instead of exercising due diligence in determining what risks their banks are taking and moving their deposit accounts elsewhere if these are above acceptable levels, most depositors rely on the protective cover not only of FDIC insurance, but also of various federal regulators who ensure that banks maintain a minimum level of liquidity, adequate capital commensurate with the market risk of their loan and investment portfolio, and orderly liquidation if they fail. …

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