Howard's Daily: The Two-Way Peril of Regulatory Ossification

Courtesy of an excellent daily compilation service called Muhr’s Must Reads, I read an essay titled "The Regulatory Confidence Cycle," by Harvard Law Prof. Mark Roe. Professor Roe warns against complacency in thinking that Dodd-Frank has shielded the economy against financial crisis like that in 2008. "Like generals fighting the last war," he warns, the protections of new regulations will not necessarily guard against new crisis.

He’s correct to a point: Regulations by themselves will almost never guard against abuse, any more than an automatic alarm system is foolproof protection against wrongdoers. Effective regulatory oversight always requires vigilance and human judgment. In the mortgage bubble crisis, pretty much everyone was asleep at the switch, relying on triple A ratings and other "objective" indicia of stability when any alert person would see that the loans were garbage. 

But the deeper problem of post-crisis regulation is that it is often counterproductive. Regulations always have unintended consequences. They cost money; they divert compliance and management energy to rote compliance rather than alert oversight. Dodd-Frank is so complex and expensive, industry insiders tell me, that it drives small banks into the arms of larger banks, arguably exacerbating system-wide risks. The real Maginot Line created the harm of complacency; regulatory Maginot Lines can cause failure by forcing people to do things that make no sense. 

The more detailed the regulation (Dodd-Frank is 850 pages; the Volcker Rule is 950 pages), the sooner and more counterproductive the unintended consequences will appear. The goal should be to focus on regulatory goals, not mindless compliance. Regulators and management alike should be always alert to new facts and trends. This is why an ideal regulatory structure, as Bank of England economist Andrew Haldane proposed in his speech "The Dog and the Frisbee," is one that is made up of broad goals and principles, not detailed prescriptions.  

To guard against the next financial crisis, the first task is not to rely upon Dodd-Frank, but to go back and radically simplify it.

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