Dodd-Frank’s Regulatory Morass

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The costly implementation of the Dodd-Frank Financial Reform Act stems from the law’s political origins.

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Four years after enactment, all 280 of the Dodd-Frank Act’s specified rulemaking deadlines have elapsed, with 45% having been missed. Of the Act’s 398 rulemaking requirements, slightly more than half (52%) have been finalized, while nearly one-quarter (24%) have not yet even been proposed. This protracted implementation of Dodd-Frank’s regulatory mandates has led some commentators to assert that the rulemaking process has been captured by banking interests. They point to intensive lobbying by the financial industry and draw the inference that such activity is both improper and responsible for delaying the implementation of the Act. But instead of industry capture, the real cause of Dodd-Frank’s regulatory morass stems from its origins in a crisis-driven, ideologically-laden legislative environment.

The fact that industry has lobbied intensively over Dodd-Frank rulemakings should hardly be surprising. It would be inconceivable, if not irresponsible, for the financial industry not to engage in intensive lobbying over proposed rules, given the financial stakes. Moreover, Dodd-Frank rules must be developed under the notice and comment procedure established by the Administrative Procedure Act, which intentionally encourages such a dialogue: agencies are expected to be responsive to issues raised by interested parties in rulemaking deliberations, as the bureaucracy is thought not to be well-situated to be adequately informed about business practices and consequently not attuned to the imposition of unanticipated compliance costs.

Most importantly, the sheer complexity and numerosity of required rulemakings under Dodd-Frank, which at times requires coordination across multiple agencies, itself contributes to slowing down any specific rule’s enactment quite apart from the additional hurdle of interest group lobbying. The most significant source of delay appears to stem from the Dodd-Frank Act itself.

Dodd-Frank and the regulatory apparatus it has imposed have generated controversy, disappointment, and alarm at virtually every turn. The law has led to the adoption of costly and burdensome regulations, many totally unrelated to the financial crisis, while failing to address key factors widely acknowledged to have contributed to the financial crisis, such as runs on shadow banks, whose liabilities were collateralized with securitized mortgages, and government-sponsored enterprises (GSEs) that guaranteed those securitized mortgages.

Rather than address shadow banking and the GSEs explicitly, the focus of Dodd-Frank directed at the subprime mortgage market’s contribution to the crisis is a requirement that mortgage securitizers retain 5% of the securities of non-qualified mortgages. This provision is informed by a mistaken premise, however, as securitizers did retain credit risk pre-crisis, as they held substantial amounts of mortgage-backed securities on their balance-sheets. As Ryan Bubb and Prasad Krishnamurthy note, banks’ retention of securitized mortgage risk contributed to the financial crisis by jeopardizing their liquidity, and ultimately solvency. Consequently, this particular Dodd-Frank provision advances a perverse regulatory strategy because it would appear to aggravate, not diminish, systemic risk created by mortgage securitizations.

In addition, Dodd-Frank inadequately responds to the after-effects of the crisis – taxpayer bailouts of “too big to fail” financial institutions. Although the law does have a section addressed to the resolution of large financial institutions, many commentators maintain that it has not resolved the “too-big-to-fail” syndrome. In fact, it could well exacerbate it. The basis for such a contention is that by identifying systemically important financial institutions (SIFIs) and subjecting them to a special regime that permits their being bailed out upon approval by designated government actors, the law simply codifies too-big-to-fail. As Peter Wallison has explained, Dodd-Frank extends the Federal Deposit Insurance Corporation’s policy of paying off unsecured bank depositors to all large financial institutions, as well as non-bank institutions that are classified as SIFIs.

But at the same time as it ignores or inappropriately addresses critical issues related to the financial crisis, Dodd-Frank imposes considerable costs on nonfinancial companies, which could well be a multiple of billions of dollars, due to time-consuming disclosure requirements whose regulatory objectives have no relation to the statute’s ostensible purpose – responding to the financial crisis (disclosures regarding conflict minerals, payments to foreign governments for oil and gas development, and the ratio of CEO compensation to that of the median employee). Even the proponents of those provisions did not believe that the issues informing their proposals had a connection to the financial crisis: the legislative majority simply opportunistically took advantage of including provisions that were desired by key constituent interest groups and had scant chance of independent enactment (as evidenced by the stalled progress of related bills and the subsequent controversy over those rules’ implementation).

Including provisions unrelated to the financial crisis in Dodd-Frank was also used strategically to secure a sponsoring legislator’s vote, which a lead drafting legislator deemed necessary for the bill’s passage. The sorry aftermath of this political horse-trading is that the U.S. Securities and Exchange Commission has had to devote time and resources to address rules quite unrelated to both the financial crisis and the agency’s core mission, a diversion further exacerbating the delayed implementation of rules with at least an ostensible nexus to the crisis, such as those relating to security-based swaps and asset-backed securitizations, along with the Volcker rule, which prohibits financial institutions’ proprietary trading. Those rules’ statutory deadlines were long missed.

The present appalling legislative and regulatory state of affairs should not be a surprise: the Act was passed in the heart of a crisis, and emergency financial legislation is inherently ill-suited for addressing crises, given information difficulties. The politics of financial crises should call for policymakers to wait to act until sufficient information is available on what might be the wisest course of action, but instead it provides an opportunity for well-positioned political actors to advance an agenda that is often tangential to the crisis at hand and may well be inapposite given the best available data.

But the making of Dodd-Frank is considerably more dismal than that of well-intentioned legislators operating in a panic and making mistakes. In a parody of the textbook behavioral response to a financial crisis, Robert Kaiser offers an eyewitness account of the enactment of Dodd-Frank in a recent book that tracks every action and reaction of Congressman Frank and his staff. The account relates that Frank objected to the appointment of a commission to study the causes of the crisis – which was being advocated by members of Congress and commentators – because it would be a “distraction.” Frank was reconciled to the commission’s creation only upon ensuring that its work would be completed after legislation responding to the crisis could be enacted.

Instead, Frank and other supporters of Dodd-Frank adopted a cartoonish contention that the crisis was caused by, in Frank’s words, “irresponsible financiers and anti-regulation Republicans.” Such a view could only be held by a poorly informed and highly partisan political actor with a sound bite understanding of the complexity of what was, after all, a global financial crisis. Unfortunately, Frank’s simple-minded view of the crisis followed straightforwardly from his world view: he was one of the representatives most to the extreme left on the U.S. political spectrum, as indicated by a widely-used ideology measure developed from roll call votes by political scientists Keith Poole and Howard Rosenthal. The failure of the Dodd-Frank Act even to address key contributing factors to the crisis related to government policies, such as the GSEs, was to be expected when its supporters acted based on strong ideological priors, rather than by a more empirically-informed decision-making.

There is an additional factor besides policy preferences of the agenda setters that informs the absence of any provision concerning the GSEs. As documented in numerous sources, the GSEs were generous contributors to election campaigns, as well as glad-handers to constituents, such as community organizers and activists, who in response lobbied legislators on the GSEs’ behalf. In the years leading up to the crisis, the GSEs’ largesse was ubiquitous. This corrupt political environment helps explain Dodd-Frank’s peculiar silence on the GSEs and government housing policy.

While the vagaries of an emergency-driven legislative process can better explain Dodd-Frank’s regulatory morass than industry capture, there is a legislative device that can address equally well both of those concerns: sunsetting the legislation and its implementing regulation. The highly public legislative reassessment, replete with hearings and independent expert analyses, of a sunset review would draw attention to captured agencies and so reassert, not undermine, democratic accountability and decision-making. Moreover, the public review of agency decisions subject to sunsetting should encourage an agency to resist industry capture from the outset, as it would be aware that its actions would necessarily be evaluated thereafter and possibly overturned.

At the same time as mitigating the possibility of agency capture, sunsetting is well-suited to deal with the problems created by crisis-based legislation and consequent regulation. By unloosening the institutional stickiness of the legislative and regulatory status quo, it sets in motion a process by which post-enactment information, including an understanding of a crisis’ causes and knowledge of enacted legislation’s unintended consequences, can be incorporated into the regulatory regime, thereby improving the quality of decision-making.

Roberta Romano

Roberta Romano is the Sterling Professor of Law at Yale Law School and Director of its Center for the Study of Corporate Law. This essay draws on her recent paper, “Further Assessment of the Iron Law of Financial Regulation: A Postscript to ‘Regulating in the Dark.’” Her earlier paper, “Regulating in the Dark,” was featured last year on RegBlog.