Dodd-Frank and Basel III fail the ounce of prevention is worth a pound of cure test

In response to our current financial crisis, the anticipation was that we would have financial reform that targeted the toxic areas of the financial system.  Instead, we have seen the unleashing of the combination of complex rules and regulatory oversight in an almost indiscriminate fashion across the entire financial system.

What is needed globally, and is particularly timely because the UK is in the midst of reforming its financial system, is to ask the question of does any specific reform pass the ounce of prevention is worth a pound of cure test.

To date, reform has been focused on a pound of cure.

Examples of this are Dodd-Frank and Basel III.  They embody a "pound of cure" in ideas like an orderly liquidation authority and more capital to absorb the losses if a bank fails so taxpayers don't have to.

What is almost completely lacking is any focus on the idea of an ounce of prevention.

This can be shown by asking does the reform prevent the problem from occurring in the first place or does it address the problem after it has occurred.  This a very tough test that any reform reliant on the combination of complex rules and regulatory oversight routinely does not pass.

Why did the combination of complex rules and regulatory oversight not pass the test as an ounce of prevention?

Our current financial crisis is the result of the failure in precisely those areas of the financial system, examples being financial institutions and structured finance securities, that are dependent on the combination of complex rules and regulatory oversight acting as an ounce of prevention.

Despite howls of protest from the financial regulatory community, we know that the combination of complex rules and regulatory oversight is not an ounce of prevention.  If it were, the current financial crisis would not have occurred.  There is no escaping this track record even if former Treasury Secretary Tim Geithner pleaded for the financial regulators to be given a second chance.

Before reforming the financial system, the question should be asked, "what parts of the financial system continued to perform without government intervention during the peak of the financial crisis".

The parts of the financial system that continued to perform included the stock and corporate bond market.  The exception in this performance were for stocks and bonds of financial institution.  These froze.  For everything else, there was a willing buyer for each seller even if the price wasn't exactly what the seller wanted.

Why?

Because these areas provide transparency so the buyers and sellers knew what they owned or were going to own.  Buyers and sellers had access to all the useful, relevant information in an appropriate, timely manner so they could independently assess this information and make a fully informed decision.

The areas that didn't perform and saw their markets freeze were all the opaque areas of the financial system.  Examples of this include the unsecured interbank lending market and the market for opaque, toxic sub-prime mortgage-backed securities.

As regular readers know, transparency is the universal ounce of prevention that is worth a pound of cure in the financial system.