Aligning Incentives: How to Make Dodd-Frank Work

Abstract:     
AIG’s eventual meltdown, in September 2008, was precipitated by a number of factors, including poor risk controls, negligent oversight by regulators, errant assessments by rating agencies, and reckless internal management. However, none of these factors was ultimately responsible for transforming AIG from an isolated corporate failure into a potential systemic disaster. What made AIG systemically dangerous was that an AIG default risked toppling counterparties to its CDS trades - these counterparties would have been left with significant and potentially debilitating capital holes in the case of such a failure. The question that is the key to preventing systemic crisis moving forward, is, ‘how did these seemingly sophisticated counterparties get into such a precarious situation?’ The answer, as will be elaborated upon in 'Section I' of this paper, is, that they were insufficiently collateralized due to incentive misalignment and difficulties with collateral dispute resolution. This begs the question: Can Dodd-Frank, as currently proposed, align similar incentive structures, and resolve analogous disputes, in the future? As will be discussed in 'Section II' of this paper, the answer is, likely, no. However, 'Section III' proposes a fundamental tweak that can make Dodd-Frank potent and prevent AIG-like crisis moving forward.

working papers series