The truth about the Dodd Frank Act

A decade after the Dodd Frank Act was signed into law following the worst financial crisis since the Great Depression, the United States has been left with three truths. There is one old, one new, and one ageless. They paint the nation a bleak picture of the success of the law to date.

The old truth remains unchanged since its inception. The Dodd Frank Act was a hasty response to the financial crisis built on a misplaced trust that government regulators had better insight into complex risk management than the private sector with its information and incentives. As part of the Financial Crisis Inquiry Commission, I argued that too little regulation did not cause the meltdown and neither did too much regulation. The key was getting the right regulation, and the Dodd Frank Act did not.

The new truth is a more peculiar animal. Time has shown that the greatest enemy of the Dodd Frank Act is perhaps the law itself. Pick almost any key feature and witness the battering it has received. Proprietary trading had nothing to do with the meltdown, meaning the Volcker Rule was a solution in search of a problem. It is not surprising that it has been diminished. The Financial Stability Oversight Council was tasked with regulating systemic risk, without any notion of the source or the magnitude of it.

The Financial Stability Oversight Council chose to single out insurance, in addition to banking, as a possible vector of economic contagion and then spent a humiliating decade backtracking with that. It now spends its time on theoretical debates over an approach based on activities to monitoring systemic risk with no clear results. The other organization, the Consumer Financial Protection Bureau, did not invent consumer financial protection, as it is sometimes claimed. It simply set it all in one place that has been deemed by the Supreme Court to be wildly unconstitutional.

There are some benefits to the Dodd Frank Act. The Federal Reserve stress tests have shown that such enhanced requirements have left banks better capitalized and more resilient than ever. Some credit may belong with risk management improvements at the banks themselves but, even if not, this testing regime is a thin saving grace because the overall cost of the legal regime has yielded few new banks and the migration of activities to other sectors. So a decade of attempts to operate under the Dodd Frank Act has done more to undo the law than all the work of its detractors.

There is a third structural truth to the Dodd Frank Act that has nothing to do with what it did poorly at an extravagant cost or what was undone by experience. The third structural truth is that what was left out of the law has been just as costly as what was included. This did next to nothing to address one of the major causes of the Great Recession, which was the housing bubble and collapse of the subprime mortgage market.

Fannie Mae and Freddie Mac, the government sponsored enterprises for housing finance, fueled disaster with a dangerous combination of private profits in good times and taxpayer bailouts in bad times. They are wards of the state and remain in conservatorship, a measure always intended to be only temporary. Yet the role of Fannie Mae and Freddie Mac in housing finance has only increased over the last decade. As the economic damage from the coronavirus pandemic rises, it might be inevitable that housing finance poses as much of a risk as ever to our financial stability.

It did not have to be this way. Congress could have skipped those failed forays of the Volcker Rule, the Financial Stability Oversight Council, and the Consumer Financial Protection Bureau. Congress could have instead focused on more capital and better prudential regulation for banks as well as important reforms of Fannie Mae and Freddie Mac. With the Dodd Frank Act likely on the books for a while, Congress would do well to enact even some of these glaring omissions to compensate for the failings of the law and to buffer the United States against the next financial crisis.

Douglas Holtz-Eakin is the president of the American Action Forum and was the director of the Congressional Budget Office for President George Bush.