It’s been months now since the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. Although the Dow and Wall Street bonuses have returned to 2007 levels, unemployment is still hovering around 9% and housing prices continue to decline. While these numbers tell us something about the health of the economy, it would be an enormous mistake to evaluate the Dodd-Frank Act based on these indicators alone. The single most important question raised by Dodd-Frank’s passage is whether the U.S. is better poised to prevent and respond to another financial crisis than it was in 2008. Unfortunately, the answer is probably not.
Even with Dodd-Frank, the U.S. still lacks a legal framework for preventing a liquidity or insolvency crisis from spreading. The “too big to fail” problem persists. In fact, given the large number of bank closures and increasing consolidation within the financial sector, the problem has arguably grown more acute since the collapse of Lehman in September of 2008. Equally problematic (and not unrelated) is the fact that the “shadow banking system“–the central conduit through which the crisis spread from a localized bank failure into a global financial crisis–remains largely unregulated.
Consider the Volcker Rule. Like the Glass-Steagall Act which separated commercial banking and investment banking, the idea behind the Volcker Rule was to prevent risk associated with certain investment products from turning into a wide-scale bank run. The Volcker Rule tried to do this by restricting banks and specified financial companies from proprietary trading with their own assets. The problem is that neither the Volcker Rule or even a return to Glass-Steagall (effectively repealed in 1999) really goes far enough in separating run-risk investments from other financial products. The point of activities restrictions on banks and financial institutions is to prevent a shock in a derivatives market, say, from spilling over into the consumer banking sector and causing a run on banks.
This is where the shadow banking system became of crucial importance during the crisis. Shadow banks are not technically deposit-taking institutions, and thus are not subject to the soundness requirements that banks face. However, shadow banking services, such as commercial paper and money market funds, resemble regular depository banks in that they lend money on a short-term basis, and their customers can typically demand repayment on short notice. These institutions are susceptible to bank runs the same way other banks were pre-FDIC, because customers can all rush to be repaid at the same moment and bring down any institution trading in these shadow banking markets (e.g. Lehman, Bear Sterns, etc).
To prevent a dangerous cascade, greater activities restrictions than those in Dodd-Frank would have to be implemented. But in light of constant financial innovation, that approach seems impracticable. Morgan Ricks, a visiting professor at Harvard Law School, has proposed an insurance regime that would do for shadow banking what the FDIC did for regular banks back in 1933. Any business financing itself in the shadow banking system would have to pay into an insurance system, and the insurance fund would step in when the firm gets too risky. Beyond limiting the threat of runs on the commercial paper and money markets that we saw in the last crisis, an insurance regime would have the added benefit of having financial institutions and not taxpayers shoulder that risk.