2010 09 RGE Steps We Must Take After Dodd Frank

Steps We Must Take after Dodd-Frank
Thomas L. Fraser
Sep 7, 2010 12:22PM
The recently approved Dodd-Frank Wall Street Reform and Consumer Protection Act does some
very good things. The establishment of the Financial Stability Oversight Council, early
resolution authority, tightened derivatives regulation and the Volcker rule are all steps in the
right direction. But Dodd-Frank does not go far enough. If the United States and the rest of the
world are to avoid financial crises and help ensure more stable economic growth in the future,
radical financial reform is necessary.
How did we get to a point requiring such fundamental change? Beginning in the 1970s, a wave
of liberalization and innovation changed the finance industry. A huge, lightly regulated shadow
banking system -- comprised of investment banks, structured investment vehicles, nonbank
mortgage lenders, money market funds and other nonbank financial institutions -- grew to
parallel the conventional banking system. Credit became much more easy for individuals,
companies, investors and the rest of the public and private sector to obtain. Lending standards
were loosened. Balance sheets became more leveraged. Monetary policy was accommodative.
Credit and asset bubbles developed.
When the securitization market froze up and confidence was lost in real estate and other markets,
the impact was severe. A number of weaknesses in the financial system were exposed.
Mortgage lending practices had been inadequately regulated. Credit rating agencies failed to
accurately price risk. Numerous regulatory and industry structural flaws became apparent. A
series of very aggressive policy measures prevented a severe recession or depression. We find
ourselves today with anemic economic growth and the threat of a double-dip recession.
Given that the causes underlying the largest financial crisis in history have been building up for
so long and are so broadly distributed throughout the financial system, it is not surprising that
fundamental, far-reaching financial reform is required.
First, the shadow banking system needs to be more comprehensively regulated. At the height of
the credit bubble, the shadow banking system was lending approximately as much money as
conventional banks were. When the securitization markets froze up, a huge amount of credit was
cut off from the economy. If the economy is to rely on the shadow banking system for such a
significant proportion of its credit, the shadow banking system must be structured and regulated
so that it can provide a level of reliability and stability similar to the conventional banking
system. Accomplishing this will require a number of regulatory reforms and industry structural
improvements, including much better regulation of loan origination practices, standardization of
securitization deal structures, significantly better disclosure and transparency requirements, and
additional credit rating agency reform.
Second, bank compensation practices must be revised to closely align risks and rewards. Due to
bonus systems based on short-term profits made over the course of a year, bankers and traders
are encouraged to take on short-term risks. Compensation practices that reward employees for
profits annually, but do not hold in escrow or claw back compensation if losses subsequently
materialize, raise significant risk. Collectively, such practices contributed to the financial crisis.
Compensation practices must be revised to reflect investment returns over their actual time
horizons.
Third, an updated version of Glass-Steagall must be enacted. Over the past few decades, our
financial system has become increasingly dominated by fewer and fewer financial institutions of
greater and greater size, concentration, complexity and interconnectedness. Having such a high
level of complexity and concentration has made the financial system increasingly vulnerable to
the kind of chain reactions that led to widespread market failures during the financial crisis. By
enacting a modernized version of Glass-Steagall and separating different types of financial
services businesses, we can reverse the long-running trend toward ever-increasing financial
industry concentration and interconnectedness and reduce overall systemic risk.
Finally, regulators in the United States and the rest of the world must move away from regulating
financial markets from product- and function-specific organizational “silos” and toward a more
comprehensive regulatory approach. As the subprime crisis demonstrated, financial markets are
incredibly complex and interconnected, much more so than even a short time ago. A failure in
one type of market can quickly affect many other markets. If regulators are to be effective in
preventing (or at least minimizing the impact of) future financial crises, they will need to take a
much more comprehensive approach to the development of staffing, institutional expertise and
regulation.
Fundamental financial reform will not happen overnight. But it is necessary. Like the credit
bubble that helped cause the financial crisis, issues arising from the inadequacies of the financial
system have been building up for a very long period of time. Reforming financial regulation is
necessary to restore confidence in the financial system and to help ensure sustainable economic
growth. The urgent and difficult work of financial reform is just beginning.
Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini
Global Economics, LLC, which encourages a free-ranging debate among its own analysts and
our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any
opinions expressed by outside contributors. We encourage cross-linking but must insist that no
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