Rules, Risk, and the Dodd-Frank: They Earned It

Whenever I see a parent who has a toddler at the end of a leash, my first reaction is one of horror.  But my girlfriend always reminds me that nobody just gets the leash. No parent arbitrarily decides putting their kid at the end of a tether would be a good idea; they do it because, at least once, their toddler tried to run out into the street. Though the Chamber of Commerce seems to be horrified by the proliferation of regulation under the Dodd-Frank Act, it’s precisely the same situation. The financial services industry earned the leash.

I try to steer away from political topics on the blog. They tend to divide people more than they bring them together and often provide more heat than light. A post by the formerly mainstream, now free-market-fundamentalist Chamber of Commerce has inspired me to break that proscription, however, because it goes directly to the issues of ethic, risk, and compliance.

The page, http://www.chamberpost.com/2011/01/dodd-frank-unleashes-a-tsunami-of-regulation-a-visual.html, features a very well-done graphic on the number and scope of rules and regulations mandated by the Dodd-Frank act.  The contention is clearly that the overwhelming profusion of regulatory activity is going to damage U.S. competitiveness as a provider of capital market services.

What it missing from the discussion is a review of why Dodd-Frank was enacted in the first place; the capital markets have proved, over and over, utterly incapable of regulating themselves. The fact is that there were trillions of dollars of real value lost in the financial meltdown of 2007/2008, and no one has gone to jail, and almost no one lost their job, and all the bankers and bond traders and rating agency executives got to keep the billions of dollars in bonuses they made in the run up to 2007. So the scoreline reads Wall Street 3-0 Main Street.

We have laws for a reason. In a world with both limited resources that must be competed for and the unlimited right to stockpile those resources, some people will do things that may not be illegal but that are unethical. In some spheres of life the social pressure against doing the unethical countervails the reward. Additionally, some people are just decent and won’t exploit others on principal. But as the rewards grow into the millions and billions, like they do in the capital markets, internal and external non-legal pressures fail and we get collusion, insider-dealing, and revolving-door quid-pro-quo deals.

Furthermore, risk is hard. All the academic research suggests that people are not wired to understand risk well, especially when it occurs at the far ends of the bell curve (we tend to overestimate rare risks and underestimate common risks). Without incentives to understand it correctly (i.e. that the companies themselves will be left holding the bag in case of failure), it gets ignored and/or externalised.

And that’s precisely what happened in the subprime, derivatives, and insurance scandals of the last half of the decade. And, as above, what essentially resulted was a huge wealth transfer from the investors and taxpayers to the financial services companies. Through both the bonuses that happened in the run-up and the the bail-out in the aftermath, the capital markets firms internalised return but externalised risk.

So while the infographic on the COC website might make Dodd-Frank seem like an overreaction, remember what it  is reacting to. There is absolutely no reason, given the evidence of recent and/or past history, to think that the capital markets can overcome the human tendencies for greed and risk ignorance. In the long run, prudent regulation makes the capital markets more competitive by increasing stability and transparency.  And that’s what really want out of Wall Street, not seven figure bonuses.