Charles W Calomiris, banking professor

The Dodd-Frank bill's failure to deal with the key problems that triggered the economic crisis is a missed opportunity.

The stated purpose of the US's Dodd-Frank financial regulatory reform bill was to fix the problems that came to light during the recent financial crisis. Three factors were particularly important in contributing to the subprime financial crisis in the US:

- Loose monetary policy and global imbalances kept US interest rates extremely low from 2002 to 2005, producing abundant credit and the underpricing of risk.

- A long list of government-supported housing finance policies by Fannie Mae, Freddie Mac, the Federal Housing Administration and other government instrumentalities subsidised mortgage credit risk by relaxing mortgage leverage and underwriting standards to encourage highly levered purchases of homes by borrowers with poor credit records and little wealth (the government-encouraged standard became an undocumented mortgage with a 3% down payment).

- The combination of predictable government protection of banks (via deposit insurance and too-big-to-fail bailouts) led financial institutions to be too complacent about risk management. Meanwhile, the failures of prudential standards to measure and constrain risk-taking permitted complacent banks to expose themselves to underpriced mortgage risks without maintaining equity capital buffers commensurate with the high risk they were bearing.

The first factor was a necessary but not sufficient condition for the financial crisis; both government sins of commission in the mortgage market (the second factor) and sins of omission in prudential regulation (the third factor) played crucial roles in producing a deep and lasting crisis. My rough calculations suggest that even in the presence of loose monetary policy and global imbalances, if the US government had not been playing the role of risky-mortgage pusher in the years leading up to the crisis, mortgage-related losses would have been cut by more than half.

Similarly, if prudential regulation had measured those outsized mortgage risks accurately, sufficient equity capital would have been required to prevent the mortgage meltdown from creating financial meltdown.

Cause and effect

Looking over the more than 2300 pages of text in the new financial reform legislation, what is notable is the lack of connections between the causes of the crisis and most of the legislation. The Pew Trusts Task Force on Financial Reform, of which I was a member, brought together a bipartisan group of prominent financial experts to suggest financial reforms and, in December 2009, the group issued a statement with detailed proposals for restructuring regulation and other government policies in light of the crisis. It is striking how little the recommendations of that group, or those of any other group of experts commenting on the crisis, influenced the Dodd-Frank bill.

The Pew Task Force recommendations do intersect with the new financial reform bill in some areas, notably the encouragement of derivatives clearing on exchanges, improvements in derivatives disclosure, the creation of a macro-prudential regulatory mandate to vary prudential requirements over the business cycle, the setting up of a consumer protection agency to prioritise the enforcement of financial standards to prevent abuse, and the creation of a resolution authority for non-bank financial institutions. But even in these areas of intersection, the legislation often misses the mark.

For example, the new resolution authority vested in the Federal Deposit Insurance Corporation (FDIC) awards it unlimited bailout authority, meaning it can now insure any debt on planet Earth against any loss. A better approach would have required unsecured creditors to bear significant but bounded losses, for example, requiring that creditors suffer the same losses as they would in bankruptcy up to some maximum proportion of loss. Bounded losses can prevent systemic problems of contagion but unbounded protection of creditors institutionalises too-big-to-fail incentive problems.

Bureaucrats in the future will likely do what they have done in the past: follow the myopic political path of least resistance during a crisis and bail out everything in sight. Knowing that, financial institutions will not take appropriate precautions. The devil, as they say, is in the detail - and the devil is certainly in the detail of the new resolution authority.

Falling short

The new consumer protection agency will be housed within the Federal Reserve, although with some independent authority. The primary motivation for a new agency was to create an entity focused entirely on consumer protection, rather than the multiple mandates of the existing regulatory agencies. Placing the new agency within the Fed is contrary to that objective. Moreover, housing it in the Fed is likely to create additional problems - further politicising the Fed and complicating its budgetary process.

The legislation pays some lip service to other bona fide reform recommendations relating to improvements of capital regulation and the regulation of ratings agencies, but the implementation of the details is left to the regulatory agencies. Congress missed an opportunity to require new elements that could have made a big difference for the regulation of risk and capital standards in the financial system. For example, many academics and some regulators favour the use of contingent capital certificates as a part of capital regulation to help overcome the too-big-to-fail problem, and many have called for fundamental reforms of the regulatory use of ratings as a means of improving risk measurement; neither of these is mandated in the legislation.

Instead, the legislation calls for studies of these (and many other) topics. Such studies, as in the past, are likely to accomplish little other than feeding the campaign coffers on Capitol Hill by inviting continuing lobbying. The regulatory agencies already possess the authority to alter capital and other prudential requirements, and are already in the process of doing so; the legislation will have little or no effect on the outcome of that process.

The Dodd-Frank legislation also promotes many pet projects of its sponsors and other influential parties that have nothing to do with the recent crisis. For example, the legislation imposes hiring quotas for women and minorities in the financial services industry. It also requires new industry-funded outreach measures to encourage people on low incomes to become more involved in the financial system.

And the law's 'Volcker Rule' and derivatives trading limits place new and ill-defined boundaries on proprietary trading and derivatives positions of banks. Those limits, if enforced rigorously, will be damaging to the ability of global US banks to perform essential client services, and are unlikely to have any redeeming benefits for controlling financial system risks (see my article, 'The Volcker Rule: Unworkable and Unwise', at

The legislation does not even mention the need to fix the main policy distortions that produced the crisis, namely the many government interventions that subsidise mortgage risk-taking by homebuyers.

If the US had maintained a reasonable, say, 20% minimum down payment standard in the mortgage market, as was typical prior to the recent housing binge, then the housing price decline of 2007 to 2009 could not have produced a financial crisis. Proposals to increase the minimum down payment from 3% to 5% on government-guaranteed mortgages as part of the reform legislation were rejected by Congress.

The failure to deal with the central problem of mortgage risk subsidisation by the government is not a surprise given that the main architects of reform legislation, US senator Chris Dodd and representative Barney Frank, have been among the main promoters of ballooning mortgage risk subsidies for the past two decades. Congressional Democrats and the Obama administration say they will be taking up house financing reform next year, but that is unlikely. After the 2010 election, Congress is more likely to be deadlocked on house financing reform for the foreseeable future.

History repeats

The failures of the 2010 financial reform are eerily familiar to historians of the 1930s. The banking reforms of that decade similarly failed to address the key causes of its financial crisis. Such failures may be inherent in any comprehensive approach to financial policy in the wake of a major financial crisis.

Comprehensive bills invite logrolling, and are a magnet for special interests and cranks, which are all too common a sight in Washington, especially after a crisis. Many of the bad ideas in the 2010 legislation probably would not have passed as isolated policy proposals judged one at a time on their merits. A reform strategy that would have considered more narrowly defined legislative efforts one at a time also would have permitted advocates of real reform to focus attention more clearly and deliberately on the necessary reforms to government mortgage financing policy, the structure of capital standards and risk measurement, the regulatory use of ratings and the design of the new resolution authority. Instead, the 2300-page bill just signed into law misses those opportunities while increasing regulatory costs, reducing credit supply and raising the risk of crises by institutionalising too-big-to-fail bailouts.

Charles W Calomiris is Henry Kaufman Professor of Financial Institutions at Columbia Business School


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