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The Error at the Heart of the Dodd-Frank Act

August 1, 2011
By Peter J. Wallison

This paper, written by American Enterprise Institute fellow Peter Wallison, examines the error underlying lawmakers’ passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010.

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This paper, written by American Enterprise Institute fellow Peter Wallison, examines the error underlying lawmakers’ passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010.

Dodd-Frank is geared towards solving the wrong problem, Wallison writes.

“The underlying assumption of the Dodd-Frank Act (DFA) is that the 2008 financial crisis was caused by the disorderly bankruptcy of Lehman Brothers,” Wallison wrote. “This is evident in the statements of officials and the principal elements of the act, which would tighten the regulation of large financial institutions to prevent their failing, and establish an ‘orderly resolution’ system outside of bankruptcy if they do. The financial crisis, however, was caused by the mortgage meltdown, a sudden and sharp decline in housing and mortgage values as a massive housing bubble collapsed in 2007. This scenario is known to scholars as a ‘common shock’—a sudden decline in the value of a widely held asset—which causes instability or insolvency among many financial institutions. In this light, the principal elements of Dodd-Frank turn out to be useless as a defense against a future crisis.”

Wallison writes that Dodd-Frank is negatively affecting many businesses, because it solves the wrong problem.

“It is possible that this effect is already being felt in credit restrictions and the unwillingness of businesses to expand and hire new employees,” Wallison wrote. “Moreover, these provisions are not likely to help prevent a financial crisis: orderly resolution will not prevent or ameliorate the effects of a common shock, and is likely unnecessary in the absence of a common shock Nevertheless, it is a legitimate question whether—simply by giving the FDIC the authority to replace the bankruptcy system under certain circumstances—the DFA reduced the likelihood of a financial crisis. In other words, if Lehman had been placed into the orderly resolution process of the DFA, rather than into bankruptcy, would that have reduced the chaos that followed Lehman’s bankruptcy? The answer to this question is fairly obviously ‘no.’”
 
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