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New financial regulation must be reframed within changing marketplace, Whitehead says

The massive financial reform legislation passed earlier this year was designed to prevent another crisis like that of 2007-08. But the new financial landscape may have as many dangerous pitfalls as the old one, according to Charles Whitehead, associate professor of law and former Wall Street senior executive.

By focusing too heavily on individual financial institutions, like banks and insurance companies, he said, rather than regulating them as elements in a larger network, the new laws may have the potential to destabilize the system further.

Whitehead spoke with journalists Oct. 12 at Cornell's ILR Conference Center in Manhattan as part of the Inside Cornell Media Luncheon.

The discussion centered on the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law on July 1. The legislation authorizes a host of regulations to increase oversight of the financial industry, protect consumers, prevent banks from becoming "too big" or "too interconnected" to fail and reduce so-called "systemic risk."

It's the first piece of major legislation to come out of the recent financial collapse -- but its approach "regulates through the rear-view mirror," Whitehead said; addressing particular problems leading up to the crisis, rather than taking account of, or anticipating, further change in the marketplace.

In the past, Whitehead noted, banks and other financial institutions were focused on managing risk -- and, reflecting that focus, regulator oversight reinforced care in risk-taking and risk management.

In today's system, by contrast, banks delegate critical functions like managing credit risk to less-regulated industries, like hedge funds, relying on credit default swaps and similar instruments to make the transfer. Hedge funds, in turn, disperse that risk to others in the financial markets.

The Dodd-Frank Act addresses credit default swaps, Whitehead said, but without taking account of the broader role they play in the system. And as banks are increasingly regulated, more functions may similarly be taken over by less-regulated segments, giving those segments more influence in the market.

"We can no longer look at parts of the financial market in separation. The hedge fund industry, for example, has increasingly taken on functions that have the potential to ripple through to the banking industry," he said. "So if going forward there's a problem in the hedge fund industry, there's also likely to be a problem outside the hedge fund industry."

The legislation also attempts to limit systemic risk, he said, but without clearly identifying what systemic risk is.

"People have a general concept of what systemic risk is, but there's no operational definition," he said. That makes managing it difficult, and could result in new regulation under the Dodd-Frank Act that is less effective or consistent.

In addition, where the reform act attempts to limit the effect any one bank can have on the system as a whole -- by imposing minimum risk requirements, for example -- it often misses the point.

"The idea is, if each separate bank is stable, then the industry as a whole is stable," Whitehead said. But "that may not always be true. In fact, as a group, banks and other financial intermediaries can become unstable."

That could happen when financial firms begin to act uniformly rather than independently, he said.

"We think of changes in the financial markets as being largely random," he said; and risk management models often assume randomness in assessing individual risk. But as new requirements take effect to stabilize individual firms, they also lead to more uniform behavior among those firms -- which could increase the risk of a systemic downturn.

So while passage of the Dodd-Frank Act may be a step in the process toward a less crash-prone marketplace, Whitehead said, it shouldn't be the last word on the issue.

"There are fault lines -- things that we have to really look at in Dodd-Frank that don't seem, so far, to be very much on the radar screen," he said.

Inside Cornell is a monthly series held in New York City featuring experts working at Cornell's centers in Ithaca, Manhattan and around the world.

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