The New Financial Deal: Understanding the Dodd-Frank Act and its (Unintended) Consequences

Abstract

Contrary to rumors that the Dodd-Frank Act is an incoherent mess, its 2,319 pages have two very clear objectives: limiting the risk of the shadow banking system by more carefully regulating derivatives and large financial institutions; and limiting the damage caused by a financial institution’s failure. The new legislation also has a theme: government partnership with the largest Wall Street banks.

The vision emerged almost by accident from the Bear Stearns and AIG bailouts of 2008 and the commandeering of the bankruptcy process to rescue Chrysler and GM in 2009. Its implications for derivatives regulation could prove beneficial: Dodd-Frank will impose order on this previously unregulated market by requiring that most derivatives be traded on an exchange and backstopped by a clearing house. The implications for regulating the largest financial institutions are more troubling. Rather than downsizing the dominant financial institutions, Dodd-Frank Act singles them out for higher capital requirements and more careful scrutiny. Although lawmakers did add several restrictions on banks’ size and scope - such as the Volcker Rule, which limits proprietary trading - these restrictions depend heavily on regulators’ discretion. Ironically, the negotiation with the financial industry over these rules could simply reinforce the partnership between the government and the largest banks.

The new resolution regime gives bank regulators the same sweeping authority to take over floundering financial giants that the FDIC has with ordinary banks. Dodd-Frank resolution will not end bailouts - all of the bank’s derivatives contracts are likely to be paid in full, for instance - and it is dangerously ad hoc, once again relying on regulatory discretion rather than clear rules that are known in advance.

After explaining these components of the new legislation and how they will work - as well as the new Consumer Financial Protection Bureau - The New Financial Deal concludes with several simple bankruptcy reforms that would curb the excesses of the new government-bank partnership, as well as ways to address international dimensions of the new financial order that are largely neglected by the Dodd-Frank Act.

Keywords: Corporate finance, banking and financial regulation, too big to fail, Dodd-Frank Wall Street Reform and Consumer Protection Act, bankruptcy law reform, derivative contracts, clearinghouse for derivative transactions, capital requirements, bailouts

JEL Classification: G21, G24, G28, G32, G38, K22, K23, K29