Dodd-Frank Financial Reform: “I’ll Have the Meatless Entrée, Please”

The administration and lawmakers are busy congratulating themselves on the “historic” Dodd-Frank legislation, the “toughest financial reform” since the Great Depression.  Sure . . . if historic is synonymous with long, costly, needlessly complex, and likely to have little impact on systemic risk, moral hazard, or the financial market opacity that exacerbated the financial crisis. 

Not all of the bill’s provisions are bad, of course, and some may even be good (though much will depend on implementation).  And there is little doubt that the legislation will significantly change the regulatory landscape and business operations of every financial institution and many commercial companies doing business in this country. 

But I join the chorus of those who believe that the bill largely fails to address the root causes of the financial crisis and the financial system weaknesses exposed by it; grants discretionary authority to regulators to perform acts already within their existing powers, such as identifying systemic risks (which they did not use before the last crisis, and are not likely to use before the next one); punts the bulk of meaningful issues to regulators; and fails to address at all items that should have been at the top of Congress’ reform list (such as the credit rating agencies and Fannie and Freddie). The mammoth bill contains by one conservative count 243 items requiring regulators from various federal agencies to fill in the rules about how the law will be implemented and calls for 67 studies to be completed. 

Dodd-Frank is at its most precise when it addresses issues wholly unrelated to financial reform.  For example, it requires each agency (§342) to establish an “Office of Minority and Women Inclusion that shall be responsible for all matters of the agency relating to diversity in management, employment, and business activities,” and “the fair inclusion and utilization of minorities, women, and minority-owned and women-owned businesses in all business and activities of the agency at all levels.”   It further requires workplace flexibility plans (§1067) for the newly-formed Office of Financial Research that include flexible work schedules, domestic partner benefits, and parental leave and childcare assistance. While laudable goals, it’s hard to envision these provisions as the key to preventing impending economic doom. And we banned those pesky Hollywood box office futures.  What a relief!  Surely that will stop the next major financial crisis in its tracks.

As Mike Dorf notes, the media and commenters have, to a much greater extent than usual, implicitly invoked public choice critiques of Dodd-Frank, noting “both: (a) that the bill leaves very important details to be filled in; and (b) that this means that Wall Street banks have the opportunity to gut whatever substantive checks the bill was supposed to provide.”  But the bill was never intended to provide substantive checks, and regulatory capture is only one basis for a public choice critique of the statute. 

The political conditions leading to Dodd-Frank were ripe for what Scott Baker and I have previously termed a responsibility-shifting delegation.  I believe it is this fact, and the obviousness with which Congress sought to accomplish it, that explains the criticisms levied at Dodd-Frank, more than concerns about regulatory capture, which (as Dorf notes) is a ubiquitous phenomenon that rarely receives popular attention.

Statutes, like contracts, can be more or less complete, but will inevitably have some gaps and ambiguities, which courts or agencies must fill.  A purposely-incomplete statute is not necessarily bad. Statutory incompleteness may allow lawmakers to harness the expertise of courts and agencies, provide the flexibility to adapt the statute to changing circumstances, or reduce the transaction costs associated with lawmaking. For this reason, one tends to observe relatively more congressional delegations in highly technical areas that require much expertise and information and in which technology may change quickly.  Financial regulation fits this description on many fronts.

But lawmakers may also leave statutes incomplete for strategic reasons.  When a statute is particularly salient to organized interest groups, the voting public, or both, lawmakers may find it politically advantageous to delegate to another branch of government the authority to fill statutory gaps and ambiguities in an attempt to shift responsibility for the negative impacts of law to other governmental branches.  For example, empirical study has shown that Congress delegates more frequently in issue areas where it may be hard to claim credit for any benefits of regulation (because they are widely dispersed or barely noticed), but mistakes can be salient and catastrophic, such as drug and product safety, workplace safety, and nuclear weapons.  Alternatively, delegation through an incomplete statute may benefit Congress when powerful interest groups are at odds over legislative language, or when the general public’s preferences diverge from those of powerful interest groups on a matter of high public salience.

The benefits of financial regulation have historically been, and continue to be, widely dispersed and barely noticed, and a powerful interest group (financial institutions) has an intense interest in the legislative outcome.  But, in the wake of the financial crisis, financial regulation – an issue of traditionally low public salience -- has been transformed into an issue about which the public cares deeply, yet has little expertise or knowledge by which to judge the success of legislative outcomes.  This renders the Dodd-Frank responsibility-shifting statute almost predictable. 

Congress will receive scant credit for good lawmaking if the financial system stumbles forth with no mishaps and much blame if it does not – like airplanes, we have come to expect crash-free financial systems, and seek someone to blame when they do. Dodd-Frank promises Congress the possibility of claiming credit for meaningful financial reform through public-interest rhetoric about “ending to big to fail” through a lengthy, complex, and “historic” statute, while blaming court interpretations and agency implementation as the cause of any errors. When viewed in these terms, a financial reform statute with more meat seems almost foolish from a Congressional perspective.

I wish that I could share Dorf’s optimistic view of Dodd-Frank as a public choice “teaching moment” – now alerted to the possibility of regulatory capture, the public will be less likely to allow it in the future.  But because statutory incompleteness is such a noisy signal, it is likely to remain an effective tool for lawmakers. Voters, able to observe only the fact that an incomplete statute has been enacted, and unaware of Congressional motivations, find it difficult to differentiate welfare-enhancing incompleteness from responsibility-shifting incompleteness.  This is particularly true in an issue area, such as financial reform, where delegations will be welfare-enhancing with some frequency, due to the high transaction costs associated with legislating with specificity, the complex and technical nature of the issues involved, and the need for ongoing flexibility. Unfortunately, ill-informed voters are left unaware of the rules of this game, permitting legislators to blame courts and agencies when later interpretations appear to undermine legislative mandates. 

Cross-posted at the Conglomerate, as part of the Dodd-Frank Masters Forum.

Comments

[Jeff Lipshaw]

Kim, are you using "complete" and "incomplete" in the same way the law & econ people refer to complete and incomplete contracts?

[Kim Krawiec]

Hi Jeff -- I am. There are many parallels in terms of the possible reasons for incompleteness in the two settings (and some differences as well). The usefulness of the analogy, we think, lies in the contract law insight that the interpretive rule should depend on the reasons for incompleteness. Thus, it would be a mistake to simply criticize statutes with gaps and ambiguities -- even intentional ones, as the benefits to incompleteness may outweigh the costs under some conditions. But the political conditions surrounding Dodd-Frank lead me to predict that harnessing agency expertise or reducing transaction costs or enhancing flexibility had little to do with the gaps and ambiguities in this legislation, which I suspect were largely driven by political accountability considerations.