The Dodd-Frank Act versus the Rule of Law

October 9, 2012

In response to the 2008 financial collapse, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank increased regulation of banks, stockbrokers, insurers and other financial institutions that are "too big -- or interconnected -- to fail" and that could require a government bailout to prevent a banking system collapse, says Roger Koppl, a professor of economics and finance in the Silberman College of Business and director of the Institute for Forensic Science Administration at Fairleigh Dickinson University, and a senior fellow with the National Center for Policy Analysis.

The Act created a board -- the Financial Stability Oversight Council -- composed mostly of the heads of various federal financial regulatory agencies, including some newly created agencies. The Council has the responsibility to identify institutions whose failure might create systemic distress -- and the discretion to impose "prudential" regulations on them different from the regulations imposed on other financial institutions.

  • Regulation is discretionary when the requirements imposed on privately owned institutions vary from firm to firm in ways that are difficult to explain or anticipate, particularly by the affected firms.
  • Discretionary regulation is contrary to the rule of law, but is consistent with the "rule of men" -- in this case, experts in financial regulation.
  • However, by their very nature, discretionary regulation cannot reliably produce the results its advocates desire; furthermore, these regulations will increase financial instability, rather than reduce it.

The discretionary regulations called for in Dodd-Frank make it difficult for people to anticipate the legal consequences of their actions. Thus, it violates one of the principal requirements of the rule of law. As Harvard law scholar Richard H. Fallon, Jr., explains, "People must be able to understand the law and comply with it." 

By replacing competitive evaluations of risk in the marketplace with centralized risk pricing, Dodd-Frank ensures that financial institutions, investors and depositors will have less information about the risks they face. And by further displacing the rule of law with discretionary regulation, the Act ensures that there will be less certainty about the future. As a result, it increases the instability of financial institutions, rather than reducing it.

Source: Roger Koppl, "The Dodd-Frank Act versus the Rule of Law," National Center for Policy Analysis, October 9, 2012.

 

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