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The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
The dodd frank financial reform act why we need it will it work
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The dodd frank financial reform act why we need it will it work

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A slideshow analyzing the Dodd-Frank financial reform act and discussing its strong and weak points

A slideshow analyzing the Dodd-Frank financial reform act and discussing its strong and weak points

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  • 1. Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Financial Reform: Why We Need It, and Why it Might Not Work Post prepared July 17, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
  • 2. The Dodd-Frank Financial Reform Act <ul><li>Main provisions of the Dodd-Frank financial reform act: </li></ul><ul><li>Sets up new Financial Stability Oversight Council to indentify and act on systemic risk </li></ul><ul><li>Creates new authority to wind up complex financial firms that are at risk of failure </li></ul><ul><li>Sets up new consumer protection agency </li></ul><ul><li>Moves trading of many derivatives to organized exchanges for greater safety and transparency </li></ul><ul><li>Limits proprietary trading by banks and ownership of hedge funds </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Photo source: http://www.house.gov/frank/photos/index.html
  • 3. Why We Need Bank Regulation <ul><li>Regulation of banking is justified by the notion that bank managers have inherent incentives to take risks greater than those justified by the public interest </li></ul><ul><li>The contagion effect: Failure of even one bank can cause runs on other banks and harm the non-financial economy </li></ul><ul><li>Moral hazard: If banks or their creditors believe they will be rescued when in danger of failing, they may not take needed precautions </li></ul><ul><li>Agency problems: Bank managers should act in the interests of shareholders, but bonuses, golden parachutes, and other incentives may lead them to take risks that are excessive from shareholders’ point of view </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Bank Run at Northern Rock, UK, 2007 Photo source: http://www.house.gov/frank/photos/index.html
  • 4. Why It Might Not Work as Well as is Hoped <ul><li>At 2,319 pages, Dodd-Frank is very complex, at a time when simplification is needed. Complexity invites a search for loopholes </li></ul><ul><li>Some important institutions, especially Fannie Mae and Freddie Mac, are not covered </li></ul><ul><li>The act puts off important choices on the amount of capital and liquidity required for banks </li></ul><ul><li>The act regulates many specific kinds of risks but does not curb the overall appetite for risk among financial institutions or deal effectively with compensation and incentive issues </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Photo source: http://commons.wikimedia.org/wiki/File:Lehman_Brothers_Times_Square_by_David_Shankbone.jpg The remaining slides analyze the Dodd-Frank Act and its possible effects using a modified version of the production possibility frontier and indifference curves
  • 5. The Risk-Return Tradeoff <ul><li>The tradeoff between risk and return for a bank can be represented as a frontier similar to a production possibility frontier </li></ul><ul><li>A movement from A to B along the frontier increases return at the cost of greater risk </li></ul><ul><li>Points like C, inside the frontier, show inefficient management of risk-return opportunities </li></ul><ul><li>Points like D, outside the frontier, cannot be reached under given market and regulatory constraints </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 6. Risk-Return Preferences <ul><li>Management preferences for risk vs. return can be represented as a set of indifference curves </li></ul><ul><li>The curves have a positive slope because return is a “good” but risk is a “bad” </li></ul><ul><li>All points on any given curve are equally preferred </li></ul><ul><li>Movement down and to the right is toward more preferred points </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 7. Management’s Optimal Risk-Return Tradeoff <ul><li>The position of the risk-return frontier is determined by market conditions and regulations </li></ul><ul><li>Management selects point A on a given risk-return frontier that gives the most preferred risk-return combination </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 8. Regulator’s Risk-Return Preferences <ul><li>Because regulators are concerned with contagion, moral hazard, and agency problems, they tend to prefer less risk, as shown by the blue preference curves </li></ul><ul><li>Regulator’s preferred optimum is at point B (less risk, less return) </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 9. Desired Outcome of Regulation <ul><li>Regulators would like to move the financial system along the frontier from point A to point B </li></ul><ul><li>Better tools to identify systemic risks might help them do this </li></ul><ul><li>Powers to take over management of banks facing danger of failure might also work </li></ul><ul><li>A third approach would be to reduce managers’ appetite for risk by reducing agency problems and moral hazard, so that they would choose outcome B voluntarily </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 10. Possible Unintended Consequences of Regulation <ul><li>Rather than changing management preferences or strategies, new regulations that prohibit specific risky activities like proprietary trading, derivatives, etc. may instead change the shape of the risk-return frontier </li></ul><ul><li>If preferences are unchanged, management may adapt to the new regulations by choosing a point like C on the new risk-return frontier </li></ul><ul><li>The unintended consequence: point C is worse than the starting point for both management and regulators </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 11. The Bottom Line <ul><li>Because of contagion, moral hazard, and agency problems, financial managers prefer more risk than regulators would like </li></ul><ul><li>Regulatory changes that deal directly with these problems can reduce management appetite for risk and lead to a better outcome </li></ul><ul><li>Prohibition of specific risky strategies while leaving risk preferences unchanged may lead to unintended outcomes that are worse from the point of view both of management and regulators </li></ul>Post P100717 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Most likely to improve outcomes </li></ul><ul><li>Better resolution mechanisms to reduce moral hazard (found in Dodd-Frank Act) </li></ul><ul><li>Better oversight to spot and fix early signs of systemic risk (found in Dodd-Frank Act) </li></ul><ul><li>Improvements to corporate governance and compensation rules to reduce agency problems (not much in Dodd-Frank Act) </li></ul><ul><li>Least likely to improve outcomes </li></ul><ul><li>Dodd-Frank restrictions on specific activities like use of derivatives, proprietary trading, and ownership of hedge funds </li></ul><ul><li>New authority to restrict specific lending practices in the name of consumer protection </li></ul>

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