Financial Reform: Why We Need It, and Why It Might Not Work

The Dodd-Frank financial reform act makes fundamental changes in the way the US financial industry will be regulated. It sets up a new oversight mechanism to spot early warnings of systemic risk, creates new resolution authority for complex financial firms, creates a new consumer protection agency, and introduces restrictions on several specific kinds of risky activity, including use of derivatives, proprietary trading, and ownership of hedge funds.

We can judge the likelihood that the Dodd-Frank Act will have its intended outcome by viewing the financial system in terms of the interaction of a risk-return frontier, shaped by market conditions and the regulatory regime, and the risk-return preferences of financial managers and regulators. Because of contagion, moral hazard, and agency problems, regulators tend to prefer a lower-risk point along the frontier than do managers.

The intended consequence of Dodd-Frank is to move the financial system downward along the risk-return frontier from management's preferred point to that of regulators. Provisions of Dodd-Frank that might help accomplish this include better oversight to avoid buildup of unnoticed systemic risks and the new authority to take over complex, at-risk financial institutions and wind them up if needed. Improvements to corporate governance and compensation practices could also have helped, although there is little of this in Dodd-Frank as finally passed.

On the other hand, provisions of Dodd-Frank that prohibit specific risk practices like proprietary trading or hedge-fund ownership carry a risk of unintended consequences. Such measures act by changing the shape of the risk-return frontier without changing management's underlying risk preferences. In response, managers will develop new strategies to reach their preferred risk-return point on the new frontier. Unfortunately, the new equilibrium is likely to be worse than the status quo ante from the point of view of both managers' and regulators' preferences.

Click here to download a free set of classroom-ready slides that develop the above points in greater detail, including a graphical analysis in terms of the risk-return frontier.