While I wait for David Skeel and William Cowan’s new book on the Dodd-Frank financial reform bill to appear next month (The New Financial Deal), I have tried to make my own assessment of what the bill means in the aggregate. In order to do this, I have read the bill in its entirety twice. The first time was when the bill was first passed, and this was in order to see if anything in it took me by total surprise. That amounts to a search for particular nuggets that jump out at you, not the “totality” of the bill. I’ll add that he experience of reading the entire thing as a “thing” made clear to me why “reading” bills before you pass them, if it is a good idea, needs to mean “reading” in a really different way. You have to read the bill with all the cross references to other legislation being amended to hand in advance, and a staff of experienced people to make sure that you know the context into which this change or that fits. One hopes, of course, that this was also part of the drafting of the bill ... but let’s pass over that detail. (Update: I just ordered Skeel-Cowan from Amazon.)
The second time around reading it was not for nuggets, but instead to try and understand the whole thing, as a comprehensive thing. I realize that this makes little sense given that it is not a “thing” but an agglomeration of many things, some of which fit together and some of which don’t. But this second time, I read it with some research help, and more importantly with the several hundred page bill summary to hand. This was partly to understand the bill, but partly to get a reality check, at least for parts of the bill in which I have a good grasp of the issues, whether the summary is accurate as to the bill and its impacts. I can report that for at least sizable chunks of the bill where I think I’ve got a strong sense, the summary is outstanding, and unless someone points out to me big areas where it is not, I’d urge those working with the bill to go to it. I am open to correction on this point, if you are genuinely expert in these matters.
My one graf takeaway on the bill is this, however. Parts of the bill have little relevance to the financial crisis, although they might still be part of an overall package of reform of financial regulation; one can always tell a story about how they have an impact on crisis through accumulations of bad issues, but realistically, whatever point they might have or not have – the consumer protection provisions come to mind – they are adjunct. If the underlying rationale and point of the bill is to alter the regulatory conditions that allowed for the development of the crisis, then it should be fundamentally about addressing systemic risk, too big or too interconnected to fail, and attendant moral hazard; complexity, complacency, and conflicts, as Steve Schwarcz says. As a substantive matter, however, the bill in total effect does not address too big or too interconnected to fail as a matter of private ordering, and so has the regulatory authority assume the moral hazard. Which leads to this dismaying conclusion: There are important parts of the bill that would make a great deal of sense (leave aside various particulars), in a regulatory environment that properly put the moral hazard of systemic risk on the private actors. To take one example – and leaving aside the WSJ editorial today about Main Street’s risk management issues – the proposal to move OTC standard derivatives onto centralized clearinghouses that would both provide greater transparency and reduce the scary information asymmetries and provide for centralized clearing. Great idea, with appropriate tweaks, in my view – until it becomes clear that because the bill does not put the risk burden on the private actors ultimately – does not force the private players to internalize their risks in derivatives trading, the clearing house and ultimately the taxpayer serve as the guarantor of last resort. The effect of an otherwise sensible regulatory change in the derivatives market, under conditions in which moral hazard has not been addressed, is not to reduce systemic risk, but to leverage it up by centralizing it in the ultimate public counterparty. The ironic result of the bill, in other words, is that by failing to address the systemic risk problem other than by telling the Fed and the Treasury and the “council” to figure it out, and so leaving too big or too interconnected to remain in place, otherwise sensible regulatory reforms that should reduce risk and increase transparency and informed pricing instead turn out to ratchet it up, leverage it up, for the ultimate government counterparty of last resort. That’s not what I was hoping for.
Long graf, yeah, I know. But while I await Skeel and Cowan’s book, I am willing to be told that this is not correct and I don’t understand what the bill does. However, if you’re going to correct me, please confine discussion to the main issue here, which is the overall impact of the bill, taken as a whole, as defined by the systemic risk question. I should also note, as I have earlier, that a very impressive theoretizing of systemic risk has just appeared from Steven Schwarcz and Iman Anabtawi, Regulating Systemic Risk. It is the most striking attempt to give an account of systemic risk that I have seen in several years; what it consists in and how it propagates. (I re-read it yesterday, and looking at the turmoil in the eurozone, wondered whether this same account could be applied to what we might call “sovereign systemic risk.” I wonder.)