BUSINESS
10/26/2010 09:33 pm ET Updated May 25, 2011

Shiller: Dodd-Frank Does Not Solve Too Big To Fail

The Dodd-Frank financial reform law does not solve the problem of "too big to fail," the implicit government protection of large financial institutions, prominent Yale economist Robert Shiller said Tuesday.

Speaking on a panel at the Buttonwood Gathering in New York City, Shiller said that while Dodd-Frank and the recent Basel III agreement will be helpful, they aren't enough to solve the problems they address. Systemic risk, which prompted government bailouts in 2008, is inherent in the modern financial machine, Shiller said. He said Dodd-Frank goes in the right direction, but warned that it doesn't go far enough.

"What we've seen so far is not going to eliminate the problem of systemic risk, because it's a very difficult problem. It involves the nature of the banking system, which is inherently vulnerable," Shiller said. "It's vulnerable to runs and collapses, just like steam engines are vulnerable."

However, Shiller said, the reform bill was the best Congress could do with the tools they had.

"The regulation changes I've seen seem to be more enlightened than I would have expected," he said. "It [Dodd-Frank] is almost a thousand pages long, in the current form. People think that is a problem. I don't think that is a problem at all. I'm impressed with Dodd-Frank. It's doing what they could do, to deal with a very complicated problem."

Shiller's fellow panelist David Rubenstein, chief financial officer of the investment firm BlueMountain Capital Management, expressed similar skepticism. More important than the existence of any specific pieces of legislation, which "maybe don't get it right 100 percent of the time," Rubenstein said, is that regulators are thinking in a new way. They're aware of the risks and, even if they can't prevent a crisis, they're at least trying to address the problems.

"People who are charged with protecting the system are taking seriously the idea of risk, maybe for the first time in a really long time -- for the first time in my lifetime," he said.

Another helpful development, Rubenstein said, has come from the financial sector, as bankers and traders are thinking about the downside of bets as much as the upside. Rubenstein said large financial institutions are taking a lesson from hedge funds, which by definition attempt to be "market neutral" -- making a diverse enough set of investments that fluctuations in the market don't affect them.

"What I'm encouraged by is that even those at the largest institutions, whether it's ... JPMorgan or Goldman Sachs, I think, are focusing as much on how you can lose money as how you can make money," he said.

Among other innovations, the Dodd-Frank Act established the Financial Stability Oversight Council, whose function is to identify and respond to threats to the financial system. Both Shiller and Rubenstein said that while FSOC could prove helpful, it won't solve the system's problems.

"It takes some personal judgment to see that a bubble is getting out of control. It can't be formulaic, and that means somebody has to be responsible and focused on that, and it's going to be an act of courage," Shiller said. "The FSOC is a committee of people who have primarily other responsibilities."

Rubenstein had a similar view. "It's comforting that they exist," he said of the FSOC. "But I don't take a tremendous amount of comfort that they're going to stop the next bubble.

"I think people need to have a healthy skepticism about any one group's ability to see the next bubble," he added. "That's kind of the mystery of the bubble, that when you're in it, nobody sees it."

Shiller, for the record, predicted the housing market crash back in 2005, when his opinion was dismissed by the larger financial community. Back then, New York Times economics columnist David Leonhardt -- himself a Yale alumnus -- called Shiller "Mr. Bubble" and said he was enjoying his "15 minutes of gloom."