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.

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

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

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

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/

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/

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/

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/

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/

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/

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>