Did Dodd-Frank Help Reduce Systemic Risk?

In response to the 2008 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was enacted on July 21, 2010 to overhaul the U.S. financial regulatory system. Dodd-Frank contains 390 rulemaking requirements, of which 274 (70.3 percent) were satisfied as of July 2016.[1] Although implementation has been slow, Dodd-Frank has wrought many changes in the financial system. One of the most visible is the increased levels of capital at bank holding companies (BHCs).

The common equity tier 1 ratio of the 31 large and interconnected BHCs decreased from 7.07 percent in the fourth quarter of 2005 to 4.82 percent in the fourth quarter of 2008, but steadily climbed to 11.82 percent in the fourth quarter of 2015. Capital levels at large and interconnected BHCs were about two-thirds higher than their pre-crisis levels. BHCs other than large and interconnected BHCs also experienced an increase in their capital levels to 12.1 percent as of the fourth quarter of 2015, about one-fifth higher than before the crisis.[2] The higher capital levels are expected to enable banks to better absorb losses and to reduce bank insolvency risk, thereby enhancing financial stability in the U.S. financial system. In a speech at the Federal Reserve’s annual economic policy symposium in August 2017, Federal Reserve Chairwoman Janet Yellen also claimed that the regulatory reforms instituted by Dodd-Frank have boosted the resilience of the financial system, promoted market discipline, and reduced the problem of too-big-to-fail.

However, the effectiveness of Dodd-Frank has been questioned by, among others, President Donald Trump, who has called for its review. On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017, which aims to repeal a series of provisions of Dodd-Frank. Is cutting back on Dodd-Frank justified? That depends in part on whether Dodd-Frank has delivered on its primary goal of reducing systemic risk.

In a recent study, I examine that question.[3] I identify a group of 24 U.S. BHCs, each with consolidated assets of at least $50 billion, the level deemed indicative of BHCs that pose the greatest risks to the U.S. financial system and the economy. Many of the strictest provisions of Dodd-Frank were targeted at these BHCs. I estimate each BHC’s systemic risk by means of the ∆CoVaR and MES approaches. ∆CoVaR is the change in the financial system’s value-at-risk conditional on an institution being in distress relative to its median state. MES is the expectation of an institution’s equity return when the financial system is in distress. Both measures have been widely used to study systemic risk. I calculate each BHC’s ∆CoVaR and MES from 1998-2015 and take asset-weighted average ∆CoVaR and MES across BHCs as proxies for systemic risk in the financial system. Both measures suggest that systemic risk in the U.S. financial system slowly increased between January 1998 and November 2002 and tended to decrease between December 2002 and May 2006. However, systemic risk began to rise after June 2006 and increased to an extremely high level at the end of 2008 following the outbreak of the global financial crisis. After 2008, systemic risk decreased quickly and returned to pre-crisis levels.

To examine whether Dodd-Frank contributed to the decrease of systemic risk, I introduce a two-step approach that combines the synthetic control method with the difference-in-differences method. The synthetic control method is used to construct a control group (synthetic U.S. financial system) that is unaffected by Dodd-Frank, and its pre-Dodd-Frank trend in systemic risk is similar to that of the U.S. financial system. Based on results of systemic risk in the U.S. financial system and the synthetic U.S. financial system, I apply the difference-in-differences method to estimate the effect of Dodd-Frank in reducing systemic risk, controlling for potential confounders in the pre- and post-Dodd-Frank periods.

I find that systemic risk in the financial system is very close to that in the synthetic system throughout the sample period. There is no apparent difference in systemic risk between the systems in the post-Dodd-Frank period. The difference-in-differences analysis suggests that Dodd-Frank did not have a significant impact on systemic risk. The decrease of systemic risk in the post-Dodd-Frank period is mainly due to the persistence of endogenous risk. I perform several additional tests regarding the predictive power of the synthetic control method, endogeneity concerns, and potential anticipation effects, and they support the robustness of my findings.

To conclude, I find no evidence to support the effectiveness of Dodd-Frank in reducing systemic risk in the U.S. financial system. Further improvements of the regulatory framework shaped by Dodd-Frank seem necessary, and banks’ governance and risk culture also need more regulatory attention.

ENDNOTES

[1] https://www.davispolk.com/Dodd-Frank-Rulemaking-Progress-Report.

[2] Financial Stability Oversight Council 2016 Annual Report. Available at: http://www.treasury.gov/initiatives/fsoc/studiesreports/Pages/2016-Annual-Report.aspx.

[3] Huang, Qiubin, Impact of the Dodd-Frank Act on Systemic Risk: A Counterfactual Analysis (January 15, 2018). Available at SSRN: https://ssrn.com/abstract=3019977.

This post comes to us from Qiubin Huang at the University of Groningen’s Faculty of Economics and Business. It is based on his recent article, “Impact of the Dodd-Frank Act on Systemic Risk: A Counterfactual Analysis,” available here.