More than a decade after the start of global financial crisis, we must reevaluate the Dodd-Frank Act

Banking rules and regulations are rewritten every few decades, frequently following a crisis. The Great Depression gave rise to the Glass-Steagall Act, which separated investment and commercial banking activities. The Savings and Loan debacle led to significant industry reform, including a “Prompt Corrective Action” rule to close weak banks before their capital is completely depleted. And Black Monday resulted in trading curbs (so-called “circuit breakers”) to prevent panic-selling.

Yes, waves of post-crisis regulation are typical and often necessary. But in the aftermath of the most recent global financial crisis, Congress’s regulatory reaction was far bigger than a wave; it was more like a tsunami.

The 2,300-plus page Dodd-Frank Wall Street Reform and Consumer Protection Act made sweeping changes to the financial landscape. It created a consumer protection agency, installed new capital requirements for banks, and reined in poor mortgage practices and risks in over-the-counter derivatives trading. Some of these changes have improved conditions; others have had unintended consequences; and some have made things worse.

More than a decade after the start of the global financial meltdown and – to continue the tidal metaphor – now that the water levels have receded, it’s time to reevaluate Dodd-Frank to determine where it’s been effective and where it hasn’t.

Take, for instance, the Volcker Rule. This regulation, named for the former Federal Reserve Chairman Paul Volcker, bans banks from using their own accounts for short-term proprietary trading. It’s meant to keep banks from making risky bets that may impact their safety and by extension depositors’ money.

There is already talk of relaxing the Volcker Rule, and for good reason. The biggest problem is that as it currently stands, the rule is nearly unenforceable because it so difficult to detect what constitutes an improper (speculative) trade. Indeed, there is nearly no way to tell whether a bank is using its own account to facilitate customer trades or speculate. This ambiguity and the demands for compliance and reporting have led some banks to grow overly cautious and withdraw from certain asset classes.  

What’s more, some proprietary trading can actually be a good thing. By maintaining a trading book and contributing to asset market liquidity by using it to match buyers and sellers, banks both aid these customers and earn fees. Proprietary trading by itself can also help to diversify a bank’s income sources, provided that risks are not excessive and taken within the overall context of the bank’s activities. This can be beneficial for the safety and soundness of the institution, its depositors and the financial system at large. The Volcker Rule needs a reformulation.

Another area of regulation that deserves a second look concerns privately-issued or “private label” mortgage-backed securities — as opposed to those issued by the giant government-sponsored entities, Fannie Mae and Freddie Mac. After the crisis, a veritable alphabet soup of regulators, including the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corporation (FDIC) and Financial Accounting Standards Board (FASB) pressed for more stringent rules around private label securitization based on the narrow issues they identified as needing fixes. It was overkill. And as a result, it is now inordinately expensive for firms to do this kind of work and many have retreated. Coordination across both domestic and global agencies that oversee securitization is needed.

This is deeply concerning. A robust mortgage market is critical for broad economic growth. Today, however, Freddie Mac and Fannie Mae issue about 60 percent of all U.S. mortgage-backed securities, and including issuance of securities using mortgages backed by federal agencies brings the total government share of issuance to around 90 percent.

The White House supports relinquishing federal control of Fannie and Freddie and returning them to the private sector. But this proposal will not induce the desired competition in the mortgage market unless regulators soften rules around securitization so that the private sector can compete with these behemoths.

Finally, there’s the challenge of “shadow banking.” As regulators put in place rules to make commercial banks safer, non-financial entities – including Amazon, Apple and Google – have begun to offer “bank-like” products and services, such as credit cards and peer-to-peer payment systems. Meanwhile, other quasi-financial firms, including Quicken and China’s Alipay and WeChat, have stepped in to provide loans. Trouble is, these non-banks operate outside the perimeter of formal banking regulation, which can increase risks for consumers, and potentially the system as a whole.

If these companies are going to act like banks and if they pose system-wide risks, they ought to operate under the same rules and requirements. Regulators need to make sure that shadow banks have risk management controls in place; that they follow appropriate financial guidelines for lending; and that they have ample provisions should their financial businesses falter. In short, regulators must require that they honor what they say they will.

To be sure, many of the regulations put in place after the financial crisis have made the banking system much more secure than it was a decade ago. Banks have more capital and more stable funding. Transparency has improved: investors have a clearer idea of what exactly they’re investing in. And the most complex, highly leveraged products that were so prevalent in the run-up to the crisis have largely been eliminated.

And yet, what is needed are some solid seawalls for where the largest waves of risk are likely to hit and some well-placed lifeguards where normal risks reside but only an errant swimmer needs saving.

Laura Kodres is the distinguished senior fellow at the Golub Center for Finance and Policy (GCFP) at the MIT Sloan School of Management. She is a former assistant director at the International Monetary Fund, where she oversaw the analytical chapters of the IMF’s Global Financial Stability Report between 2007 and 2013.