The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated

Abstract:     
Several commentators have argued that financial “reform” legislation enacted after a market crash is invariably flawed, results in “quack corporate governance” and “bubble laws,” and should be discouraged. This criticism has been specifically directed at both the Sarbanes-Oxley Act and the Dodd-Frank Act. This article presents a rival perspective. Investors, it argues, are naturally dispersed and poorly organized and so constitute a classic “latent group” (in Mancur Olson’s terminology). Such latent groups tend to be dominated by smaller, but more cohesive and better funded special interest groups in the competition to shape legislation and influence regulatory policy. This domination is interrupted, however, by major crises, which encourage “political entrepreneurs” to bear the transaction costs of organizing latent interest groups to take effective action. But such republican triumphs prove temporary, because, after the crisis subsides, the hegemony of the better organized interest groups is restored.

As a result, a persistent cycle that this article calls the “Regulatory Sine Curve” can be observed: the legislative success of the latent investor group is followed by increasingly equivocal implementation of the new legislation, tepid enforcement, and eventual legislative erosion. This article traces that pattern with respect to both the Sarbanes-Oxley Act and the ongoing implementation of the Dodd-Frank Act.

This article does not deny that “reform” legislation often contains flaws (as does much deregulatory legislation). But these are usually quickly eliminated in the latter half of the cycle. The greater dilemma is instead whether the problem of systemic risk can be satisfactorily addressed in the presence of the Regulatory Sine Curve.

Number of Pages in PDF File: 85

Keywords: Dodd-Frank Act, Sarbanes-Oxley Act, financial regulation, latent group, securities regulation, regulatory sine curve, Basel III

JEL Classification: E58, G18, G28, G30, G32, G38, K20, K22, K23

Accepted Paper Series