NYU Stern Releases New Book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance
More Than 40 Faculty Provide Definitive Analysis, Offer Solutions to Fix the Act's Flaws to Avoid Future Crises
New York, NY - November 3, 2010 - NYU Stern School of Business today announced its latest book on the financial crisis, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley; November 2010), edited by Professors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson and Ingo Walter. Regulating Wall Street follows the authors' previous book, Restoring Financial Stability (Wiley, March 2009), which focused on the causes of the financial crisis and offered proposals for market-based solutions while capturing the attention of policymakers in Washington.
In response to the Dodd-Frank Act, the most significant U.S. financial regulation since the 1930s, the faculty returns with a strong call-to-action to regulators. More than 40 NYU Stern finance, economics and accounting professors stress key flaws in the bill, and how these failures could set the next global financial crisis in motion.
"In our book we provide a detailed description of each part of the Dodd-Frank Act, an economic appraisal of its strengths and weaknesses, and a careful examination of key omissions that we think regulators need to urgently consider, since failure to do so could lead to the next crisis," said Matthew Richardson, Charles E. Simon Professor of Applied Financial Economics at NYU Stern, and one of the book's editors. "It is extremely critical to carefully examine each of the flaws in this highly uncertain climate where new capital allocation structures continue to develop in the shadow banking system."
As 11 different regulatory agencies now begin the process of adopting the Act's 243 new formal rules, the faculty offer key proposals to integrate into this critical legislative step whose outcomes, due by December 2011, will shape the future of global financial architecture for years to come. The following provides an outline of some of the major criticisms of the Act and the Stern authors' corresponding recommendations:
Flaw #1: Government guarantees remain mispriced in the financial system, leading to moral hazard.
- Problem: The Dodd-Frank Act needs to address the fact that financial institutions can still finance their activities at below-market rates, effectively a subsidy, that encourages them to take on excessive risk. Examples include the pricing of FDIC insurance, guarantees of the debt of GSEs, Fannie and Freddie, and the implicit insurance implied by Too Big to Fail.
- Recommendation: Dodd-Frank should recognize and charge financial firms for these guarantees where they exist. Furthermore, the book describes more credible resolution plans to deal with failures of every type of institution, so that market discipline can be restored to financial markets.
Flaw #2: The Act does not sufficiently discourage individual firms from putting the system at risk.
- Problem: Firms need to be held accountable not just for their own losses, but also for the cost that their activities impose on others in the system. To this extent, the Act falters in addressing directly the primary source of market failure in the financial sector: systemic risk.
- Recommendation: The book contains specific proposals and methodologies for measuring systemic risk and assessing financial institutions for their contributions to systemic risk.
Flaw #3: The Act falls into the familiar trap of regulating by form rather than function.
- Problem: By solely addressing the failures of banking institutions, regulators are excluding the systemically important shadow banking system that serves similar functions, such as clearing houses or money market funds. Excluding these groups of institutions makes the system vulnerable, prohibits access to emergency funding, and creates an unlevel playing field.
- Recommendation: The book suggests that it is imperative the Act address the shadow banking system and its resulting systemic risk, and treat many shadow institutions in the same way it treats banks. Doing so will better account for the sources of systemic risk and limit the amount of shadow activity that is dangerous and unregulated.
Flaw #4: Regulatory arbitrage is not adequately addressed, so large parts of the shadow banking sector remain in their current form.
- Problem: The tale of this crisis was that large, complex financial institutions exploited capital regulatory requirements to take a concentrated one-sided bet, and other parts of the financial system managed to avoid requirements all together by operating in the "shadows." Many of the problems can be sourced to the Basel Accords and its approach to regulation.
- Recommendation: The authors recommend a regulatory architecture based on taxes rather than regulations to discourage risky activities, focusing special attention on OTC derivatives, repo and money markets.
New York University Stern School of Business is one of the nation's premier management and education research institutions, engaged in leading the dialogue between business and society. NYU Stern offers a broad portfolio of academic programs at the graduate and undergraduate levels, all of them informed and enriched by the dynamism, energy and deep resources of New York City.
Joanne Hvala, NYU Stern
Jessica Neville, NYU Stern