Dodd-Frank Financial Reform: Non-Market Risks and Strategies

Economists Ink: A Brief Analysis of Policy and Litigation


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is a special consultant for Economists Incorporated and the Gleed Chair of Business Administration at Seattle University’s Albers School of Business and Economics. This article is based on a paper he wrote with Fred Karlinsky and Richard Fidei that is forthcoming in Banking & Financial Services Policy Report.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 promises to strengthen financial market performance by, among other things, “improving accountability and transparency.” The Dodd-Frank Act, however, appears to create risks for economic performance through at least two channels. Its reforms to board governance both in the Federal Reserve System (the Fed) and in public corporations may increase “accountability and transparency,” but may also risk institutionalizing more inflationary monetary policy and less productive business associations.

While Dodd-Frank’s changes in corporate governance reforms have received more attention, its changes to how the Fed is governed may be just as or even more important. Lawmakers have long criticized presidents of the Fed’s District Banks for lacking accountability to the public. An important part of this problem, it is argued, is the conflict of interest that comes from allowing private-sector directors (who work for banks) to vote for District presidents (who regulate banks). Dodd-Frank attempts to remove this conflict by taking away the ability of Class A directors (who are nominated by and represent member banks) to vote for District presidents.

But increasing accountability in this manner may also compromise an important firewall against political pressures for inflation. Commercial bankers have a financial stake in low inflation; their assets are loans, the value of which decreases with the prospect of being paid back with a weaker currency. Moreover, other members of the Fed’s monetary policy committee (i.e., Federal Reserve Board Governors) are already more accountable to the public and, according to academic studies, have long favored looser monetary policy than do District presidents. The Act’s weakening of commercial bankers’ role in the monetary policy process may thus institutionalize a more accommodative stance on inflation.

Dodd-Frank’s attempt to increase corporate management’s accountability to shareholders also appears to create new risks. Under the Act, the Securities and Exchange Commission (SEC) has stronger authority to (a) ease shareholder access to corporate proxies and (b) require corporations to give shareholders a non-binding “Say on Pay.” These provisions aim to strengthen the ability of shareholders to monitor and control their managerial agents, but may also make incorporation a less productive form of business association.

Rather than improve corporate governance, the Act’s strengthening of shareholder power may threaten the interests of other corporate stakeholders. Indeed, research highlights how these stakeholders may respond in ways that protect themselves but weaken business performance. Bond market participants, for example, may demand higher interest rates to compensate for the prospect of boards’ overly favoring shareholders’ preferences for relatively risky projects. And suppliers of human capital, such as individuals offering managerial talent, may demand insurance-like measures to offset an increased risk of having their firm-specific investments expropriated. Finally, anti- takeover provisions may increasingly become a part of initial public offerings (IPOs) if, in this new institutional setting, non-owner stakeholders face greater risks from opportunistic changes in control upon going public.

Understanding how boards become exposed to new risks when various groups strategically anticipate and react to institutional changes is important for developing legal, operational and transactional strategies that consistently succeed in a rapidly evolving regulatory environment. Organizational planners, for example, can benefit from measuring the increased risks of going public under a corporate law that now gives shareholders a stronger voice in both governance and business judgments. Those planners also should consider how charters and bylaws might mitigate the potential for and consequences of those increased risks.

Risk managers in legal, operational and transactional roles can also benefit from a deeper understanding of Dodd-Franks’ reforms to board governance of both corporations and the Federal Reserve. For example, modified loan covenants may help protect against changes in corporate strategy that would favor newly empowered stockholders at the expense of lenders. Such protections could facilitate a mutually beneficial decrease in the cost of capital. Various hedging strategies may also be productively revisited with an eye toward increased inflationary pressures on monetary policy.

Finally, proxy advisors may benefit from considering the new law’s risks. Dodd-Frank’s easing of proxy access, for example, may broaden the interests that compete for consideration from boards, thus weakening the stability of corporate policy. And both the Act’s “Say on Pay” and its easing of proxy access may turn de jure non-binding votes intode facto binding votes, thereby changing how management bargains with potential dissidents.

The Dodd-Frank Act has created risks in at least two ways that are important for professionals in organizational planning, risk management and proxy advising. First, the Act reshapes the Fed in a way that may institutionalize a more accommodative stance on inflationary monetary policy. Second, it strengthens the voice of shareholders in a way that may benefit shareholders at the expense of other corporate stakeholders rather than improve business performance more generally. Businesses should gauge exposure to these risks before they are realized and develop strategies in anticipation of how the numerous rule-making processes and judicial reviews that will follow the Act can further reshape the non-market environment in which businesses must operate. More generally, professionals in law, finance and business can benefit from appreciating the economic fundamentals that give rise to non-market risks, an appreciation that can help them develop productive strategies to succeed in a rapidly evolving institutional environment.