Dont give up on sensible ideas of Dodd-Frank Act

Written by Bloomberg | Updated: Dec 29 2011, 05:42am hrs
More than three years after the US financial system went into free fall, the Dodd-Frank Act, Congresss primary effort to prevent a repeat episode, has become something of a bete noire. Executives at big banks say the law will bog them down in costly regulations. Republicans want to repeal it. Presidential hopeful Newt Gingrich even suggests jailing its authors, representative Barney Frank and former Senator Chris Dodd.

The vilification of Dodd-Frank is odd, given that most of the law has yet to take effect. The law firm Davis Polk & Wardwell estimates that as of December 1, only 74 of the 400 required rules had been finalised, and 154 had missed the laws deadlines.

Most people, quite understandably, havent had the time or patience to wade through the laws 848 pages. As a service to them, we did so. What we found, admittedly cloaked in eye- glazing language, was an elegant core of sensible ideas. Consider it a fail-safe system with three levels of containment.

Level 1 is designed to make disastrous mistakes at financial institutions less likely. One central element is transparency: Bank stress tests, centralised reporting of derivatives trades and a data-analysis arm called the Office of Financial Research will give regulators, investors and journalists more information. They can use it to identify dangerous concentrations of risk in banks, investment firms, insurers and other financial entities.

The law also rearranges some incentives. By stipulating that lenders must hold a portion of the mortgages they originate, Dodd-Frank reduces the temptation to make bad loans and sell them off to greater fools.

Level 2 aims to make financial institutions better able to survive when mistakes do happen. The crucial piece here is higher capital requirements. Like equity for a homeowner, capital allows a bank to stay solvent if the value of its investments falls.

Stress tests conducted by the Federal Reserve play a role, too. By simulating how a bank would fare in worst-case scenarios, they help ensure that banks dont report fictitious capital. The Volcker rule, for its part, helps limit trading losses, which tend to eat into capital.

Level 3 seeks to make sure that if a financial institution does fail, it wont bring down the whole system. The law gives the Federal Deposit Insurance the power to take over a troubled institution and wind it down in a way that limits contagion a task made easier by living wills and better information on how financial institutions are linked.

In derivatives markets, banks, hedge funds and other players must put up enough collateral to pay off their immediate obligations if they run into distress to reduce chances that a large, complex institution can wreak the kind of havoc that Lehman Brothers and American International did in 2008.

Dodd-Frank contains many more rules, some quite burdensome. But bank executives such as JPMorgan Chase CEO Jamie Dimon have aimed their criticism largely at the new capital requirements and the Volcker rule. Although potentially bad for bonuses, those are among the provisions that promise the greatest net gain for the broader economy.