Following the global financial contagion, most commonly known as the US Housing Crisis, congress compiled a law known as the Dodd Frank Act signed in 2010. The general objective of this law was to address consumer finance safety, and the issue of moral hazard within the banking industry. Moral hazard refers to an issue where banks engage in risky investments or irresponsibly manage certain assets, while relying on a precident of government rescue under instances of default or bankruptcy. This summary attempts to address a few subsequent costs and benefits that have unfolded as a result of this bill.
According to a research article published through the Bipartisan Policy Center titled Did Policymakers Get Post-Financial Crisis Right? The financial system has been made safer in the following ways. Greater liquidity requirements have been placed upon risky institutions, and individual consumers of debt are better protected through higher credit standards and more transparency inside contracts. Banks have been subject to higher standards of stress testing (simulations of financial crisis), if an institution does not hold adequate capital to withstand dramatic losses, the firm will fail the test, and will have to restructure its business model. Under the Dodd Frank Act, required capital levels are contingent on how risky the firm’s transactions are, thus warranting higher levels. For example, derivatives trading is a prime example of stressful transactions, therefore, the number of these transactions and the level of risk associated will warrant certain liquidity levels. One example of liquidity requirements for large financial institutions is the holding of a certain amount of convertible bonds on their books; thus allowing for emergency liquidation under instances of asset devaluation. Convertible bonds are financial instruments that allow the holder of the bond to convert the debt instrument to an equity asset (a stock), and sell it immediately on the open market. These debt instruments also prove very helpful under situations of bankruptcy.
It is important for one to examine the costs and benefits of consumer finance regulation, as it exists today. These are specific regulations that are part of the Dodd Frank Act. While these regulations have improved the safety and stability of our financial system, they have also stunted innovation and growth within the greater economy. Banks have been subject to higher capital standards, and as a result of their price to book ratios, their shares have been less appealing to investors. Therefor equity raised through stock issuance has dropped and affected the number of loans extended to consumers. When shares are traded at a discount as opposed to a premium this often leads to lending constraints and greater susceptibility to financial shocks. Unfortunately, this is often the result of policy, there are always tradeoffs, never solutions. The hope, however, is that our financial system will be safer, and tax payers will no longer be affording the bill for the mistakes of large financial firms.
