In this note, FedFin managing partner Karen Petrou offers her views on Dodd-Frank five years later.  With apologies to Tennessee Ernie Ford, her title makes it clear that, five years after Dodd-Frank, she’s a little bit older and deeper in doubt.

The doubt is, she says, that the financial system could today better withstand a crisis any better than it did in 2008.  Sure, big banks are under far tougher prudential rules.  But, rules for activities and practices at banks and non-banks are, though, barely touched, with the four SIFI designations done so far scant – not to mention wrong-headed – action to govern non-banks with systemic   potential.

The U.S. financial system is thus shifting to one with more and more dependence on non-banks and greater volatility and illiquidity.  This might be acceptable – might be – if U.S. resolution protocols ensure that the failure of any financial behemoth – bank or non-bank could be handled through bankruptcy without macro damage to the financial system or broader economy.  But, five years later, the U.S. resolution framework remains a piecemeal affair for banks, and non-existent for non-banks.

The Fed appears to have bowed to this reality and changed its Dodd-Frank strategy to one largely focused on U.S. G-SIBs.  Monday’s surcharge rule is predicated on costing banks so much in capital for the cost of their rescue that no big bank wants ever to be that big again.  FedFin will shortly analyze the structural and strategic impact of this rule, but the FRB’s action reinforces Karen’s conclusion:  big banks are coming under high-cost rules as a proxy for broader, better systemic regulation and resolution standards.

That systemic standards and – even more important – resolution protocols are hard to write is clear, but five years on, their absence is keenly felt.  Systemic risk at G-SIBs may be quashed, but markets adapt.  As a result, Karen argues that the U.S. financial system may well be even more vulnerable than it was in 2008.

Dodd-Frank: Five Years Later and What Do You Get? A Lot of Days Older and Deeper in Doubt

With Congress and even the Presidential election embroiled in battles over what Dodd-Frank did and how much of it must be preserved as is, the fifth anniversary of the post-crisis landmark law is not just an historcal event, but also a critical policy junction. Many believe that the largest banks and other big financial institutions remain both too big to fail and jail five years on, trying to rewrite the law to rewrite or just repeal the systemic regulatory and resolution standards. Others agree that big banks are still ungoverned behemoths, but instead propose to make Dodd-Frank still tougher and go still further by also resurrecting the Glass-Steagall Act. Outside the administration and some of the federal financial agencies, almost no one believes the law is working as it should. Here, I assess why this is and what now could be done about it.

Dodd-Frank was supposed to make the largest U.S. financial-services firms safer and ensure that those that still falter could no longer topple the financial system. Despite progress on both the regulation and resolution fronts, I do not believe either of these goals are met. Big banks are indeed more stringently regulated, but non-banks remain largely as before. Resolution protocols for big banks are also advanced, but none are final nor do any handle cross-border resolutions or those of large non-banking organizations. Importantly, this asymmetric regulatory framework has now created new systemic risks, risks for which policy-makers are as ill-prepared as they were for the 2007-2008 debacle. I below analyze:

  • why Dodd-Frank’s rules are so long in coming;
  • how the financial-regulatory framework is now constructed; and
  • what should now quickly be done to meet Dodd-Frank’s most critical goal – a U.S. financial system that can be reliably counted upon to discipline itself so that no firm’s failure requires taxpayer bail-out to avert disaster.

Why So Long and So Hard?

Websites are replete with tables showing the thousand or so rules Dodd-Frank demands and how many have yet to be finalized. The formidable task of Dodd-Frank build-out demonstrated by these charts has led regulators often to argue that, given what Congress told them to do, they aren’t really doing all that badly. I don’t agree.

Sure, the law demanded a lot, failed to set priorities, and is all too often contradictory. The law also requires formal notice-and-comment proceedings that take time, as well as cumbersome cost-benefit analyses that slow them down still more.

But, the rule of law does not mean a descent into endless footnote-chasing, detail perfecting, and countless hours of unproductive negotiating among fractious regulators with competing jurisdictions – or it shouldn’t. Dodd-Frank’s rules have been so slow in coming and so complex upon arrival because:

  • the Financial Stability Oversight Council, charged with organizing and prioritizing the systemic regulatory roll-out, was moribund until 2013 and only somewhat more effective since;
  • lawyers and economists have so controlled the rule-writing process that major regulations are often sidelined for smaller projects that are easier to handle. When complex issues are tackled, often largely in the absence of clear instruction from top-level officials, endless research is all too often undertaken to validate every assertion upside down and backward; and
  • the most critical planks of the Dodd-Frank framework – systemic regulation and resolution – are often left for last. Sometimes, this is due to statutory deadlines that force attention to other priorities, but all too often it results from a lack of policy guidance from the top, and it takes more time to write rules that read more like doctoral dissertations or law-review articles than directives for real-world financial-services firms.

How Risky is U.S. Finance Now?

As Secretary Lew and others have said, Dodd-Frank can best be judged by its results. They thus argue that it’s working reasonably well because:

  • big banks are holding lots more capital and liquidity than before the crisis;
  • the resolution framework is being developed; and
  • nothing really bad has happened since 2010 despite a couple of near-disaster brushes with systemic risk.

All of this too is true, but unpersuasive if one asks the hard questions about what Dodd-Frank was supposed to do: make the U.S. financial system stronger and safer. Much in the law addresses these issues, but the architectural supports of the entire Dodd-Frank edifice are to be found in the law’s first two titles, each of which headlines its purpose to be “financial stability.” Title I establishes the systemic-designation and regulatory process, laying out the FSOC’s structure, the rules to govern designated firms, the types of activity-and-practice rules that could also be mandated, and how large bank holding companies and designated non-banks are to ensure they can be shuttered under operation of the U.S. Bankruptcy Code. Title II defines the orderly liquidation authority (OLA) to be kept on hand in the event sweeping financial shocks overwhelm the tightly-regulated firms and market-resolution protocols mandated by Title I.

If this works, everything else in Dodd-Frank is commentary. Useful commentary in many cases, but commentary nonetheless because each of the risks now so evident from the partial build-out of other Dodd-Frank requirements – e.g., central clearing – would be forestalled by prior regulatory-and-resolution requirements. Further, the all-too-evident market distortions resulting from disproportionate regulation for like-kind financial products would be far better addressed in

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