The financial crisis of 2007-08 emanated from a complex set of domestic and global forces. But at its heart was the threatened and actual collapse of large financial institutions -- Bear Stearns, Lehmann Brothers, AIG, etc. -- and, especially, the large domestic banks. The Dodd-Frank Wall Street Reform and Consumer Protection Act's (Dodd-Frank) legislative response to the crisis created new agencies and bureaus, changed capital requirements, revamped securitization rules, changed the oversight of derivatives, imposed the Volcker Rule, and had provisions for corporate governance. Dodd-Frank turns five years old next week and the occasion merits a review of its success.
And there has been some success. In part due to Dodd-Frank (and in part due to the lessons of experience in the crisis) the large U.S. banks -- denoted Global Systemically Important Banks (G-SIBs) -- look very different. They now have roughly three times the liquidity and five times the loss-absorbing capacity than at the time of the crisis. Indeed, the stress tests reveal that after the worst scenario the G-SIBs would have more capital than they actually had at the time of the crisis. Put differently, if the crisis hit today, there would be no need for a Troubled Asset Relief Program (TARP) to "bail out" the big banks. (Some of the regional and smaller banks would likely still need TARP-like assistance.)
But it is not all good news. Dodd-Frank was incredibly poorly targeted. With the sole exception of AIG's credit default swaps, derivatives had nothing to do with the crisis. Despite this, Dodd-Frank created a vast new regulatory apparatus surrounding derivatives that harmed the ability of end-users to hedge their exposure to financial risks. Similarly, even though there is no evidence that proprietary trading by banks contributed to the crisis, Dodd-Frank contained the complicated and costly Volcker rule that has inadvertently served to reduce market-making and liquidity. It even wandered into the territory of conflict minerals with devastating unintended consequences in Africa.
Perhaps most remarkably, Dodd-Frank did nothing to reform housing finance. Housing finance was at the center of the financial crisis. Yet, nearly eight years later the central actors in the crisis - Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA) - remain essentially unchanged. The flawed housing businesses remain wards of the state, and a continued threat to the taxpayer.
Dodd-Frank also created the Consumer Financial Protection Bureau (CFPB) and the Financial Stability Oversight Council (FSOC). The CFPB was unnecessary - the Federal Trade Commission already protected consumers - and was created with off-budget, slush funding via the Federal Reserve and inadequate accountability to Congress. Its performance to date has been costly and counterproductive.
The FSOC is a similar policy misstep. There is a legitimate debate about the desirability of a so-called macroprudential regulator. But there can be little disagreement that the FSOC is off to a poor start in its efforts to identify systemically important financial institutions (SIFIs). The substance of designating a SIFI focuses too much on mere scale, and too little on the activities and products of a financial institution. In addition, the process is hampered by a lack of consistency and transparency.
Taken as a whole, Dodd-Frank spawned an enormous regulatory burden. To date, 117 regulations have been finalized that actually quantified costs or paperwork hours. These impose compliance burdens of $24.9 billion and 61.7 million paperwork hours. Perhaps most amazing, Dodd-Frank remains a work in progress as there are over 400 regulations required to implement the law. It is not possible to quantify the full impact, but the bill will be expensive and quite likely has already begun to slow the pace of U.S. economic growth.
In the aftermath of the financial crisis, it was inevitable that the private sector and regulators would seek to provide a greater capital cushion and enhanced liquidity to reduce the likelihood of future crises at large financial institutions. It was not inevitable that it would simultaneously burden the economy with a poorly-targeted, burdensome, anti-growth explosion of new regulations full of policy missteps and unintended consequences. As Dodd-Frank turns five, that remains its legacy.