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Dodd-Frank: Better than advertised but still flawed

A year ago President Obama signed into law the Dodd-Frank financial services regulatory overhaul. It was the most ambitious and controversial regulatory rewrite of the financial industry since the 1930s.

Our guest writer is a close observer of Dodd-Frank. Mark Thoma, professor of economics at the University of Oregon, is best known as the blogger behind Economist View. The top-rated economic blog is a must-read for anyone that follows the topic in all its dimensions--from public policy to economic theory.

Thoma as editor smartly plucks out the best econ articles on the web. Thoma as economist judiciously contributes his own insights. You can also follow his blog Maximum Utility at the website Moneywatch.com. His columns for Fiscal Times are here.

Mark Thoma: Ineffective regulation of the financial sector was a key factor in the financial meltdown, and the Dodd-Frank financial reform bill is an attempt to close the regulatory holes exposed by the financial crisis.

The Dodd-Frank legislation made important changes in how the financial sector is regulated. It established the Consumer Financial Protection Agency to protect consumers, and it forced derivatives onto organized exchanges so that investors can monitor risk more effectively. In addition, the legislation gave regulators the ability to step in and close large banks in an orderly fashion. This authority was missing when the crisis hit, and that left regulators the choice of either bailing the banks out, a politically unpopular option, or doing nothing. Now regulators have the additional option of temporarily taking control of the banks, throwing out management, and putting the losses on investors rather than taxpayers. Thus, this part of the bill is an important step forward.

The legislation also required audits of many Fed activities that were previously secret, it reinserted barriers between commercial and investment banking through the Volcker rule, it established new ways to monitor systemic risk, and it imposed a variety of other restrictions such as limits on leverage, capital requirements, and executive pay restrictions. There are also provisions requiring regulators to study the conflict of interest that occurs when ratings agencies are paid by the firms issuing the assets they are rating.

These are all positive steps, and we are much better off with these changes than without them. However, in nearly every case the rules are weaker than needed, and I worry the legislation will be weakened further over time.

And when it comes to the most important problem we need to fix, runs on the shadow banking system - i.e. runs on investment banks, hedge funds, etc. that were at the heart of the financial crisis - the legislation is largely silent. The financial crisis can be viewed as a traditional bank run on the shadow banking system. The shadow banking system does not have the equivalent of the deposit insurance that exists in the traditional system to stop bank runs, and as the crisis unfolded and depositors in the shadow banking system became worried that their deposits might not be safe, they rushed en masse to withdraw their funds. This caused widespread problems as funds needed to finance daily activities dried up. As the New York Fed noted recently, this vulnerability still exists and that's a big worry.

With the debt ceiling debate and the troubles in Europe looming over us, the failure to fix this problem could be quite costly. If a run on shadow banks begins due to concerns over either issue it will be difficult to stop, a fact that highlights the bottom line: Despite all the good things Dodd-Frank has accomplished, there is still much more that needs to be done.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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