Following final approval of the sweeping Dodd-Frank Wall Street Reform and Consumer Protection Acton July 15,Obama administration officials are now addressing audiences across the country to explain how and under what timetable they plan to implement the law’s broad intentions. The legislation is designed to limit widespread risk in the financial system and to solve the problem of large financial institutions that expect government bailouts because they are “too big to fail.” It also creates new regulatory oversight and consumer protections.

In separate speeches at Wharton this month, Neal Wolin, deputy secretary of the U.S. Department of the Treasury, and Diana Farrell, deputy director of the National Economic Council, outlined the administration’s plans to protect against some of the risks that led to the global financial crisis. In reaction to their presentations and the law’s approval, Wharton faculty say the legislation is a good start toward future financial stability, but they also warn that significant concerns remain unaddressed, and stress that the details of implementation must be handled carefully to avoid creating new problems.

“I don’t think there’s a full appreciation of the major transformation of the financial structure that is upon us,” notes Wharton real estate professor Susan Wachter. “In part, that is because the bill itself sets up a framework with the potential for major initiatives, but leaves tremendous scope for regulators to interpret and carry out the mandates.”

Wharton finance professor Jeremy Siegel agrees that the details of the new regulatory mechanisms that are evolving will be critical. “The regulators who are chosen could do harm or they could do good, depending on their view and understanding of the problems.” For now, Siegel says he finds much to like about the legislation. He highlights provisions that limit leverage at large financial firms and establish a more clear-cut pecking order for claims payments to holders of debt and equity should an institution fail.At the same time, Siegel applauds legislators for resisting the simple response of setting an “arbitrary” limit on the size of financial firms to limit the problem of companies that are “too big to fail.” “That would have been disastrous competitively for U.S. financial firms,” he says.

The creation of the new Financial Stability Oversight Council — designed to watch for systemic risk that could topple the entire financial system and comprising representatives of nine federal agencies and an independent member from the insurance industry, in addition to five non-voting members — has the potential to help avert a future crisis, Siegel states. The new body is expected to meet for the first time in early fall. “The Fed certainly fumbled the ball in the last crisis by not understanding the risk that was being taken,” he adds. “It might not be bad to have another set of eyes on excesses in the market to see what is justified and what is not.”

However, he warns, there is a danger that the council could become “overbearing.” It is possible that new innovations in finance might not be fully understood by council representatives, Siegel says; as a result, the council might choke off potential sources of new growth out of concern that the financial services industry is again tilting toward overexpansion. Siegel also objects to plans to house new consumer protection oversight with the Federal Reserve, arguing that existing agencies already have the power to make many of the changes that are proposed. He does approve of additional regulation of fees charged for debit cards because of a lack of competition in that industry.

Wharton finance professor Franklin Allen has concerns about the extent to which the new legislation can prevent future crises. “It’s a good step forward — much better than I expected it to be,” Allen notes. “However, I think it misses a lot of the big picture issues.” For example, establishing the council to monitor systemic risk would not have prevented the current problems, which were centered on dramatically low interest rates set by the Fed that spurred a massive housing bubble and subsequent collapse. “The question is: What is the systemic risk council going to do? Is it going to tell the Federal Reserve that it needs to raise interest rates? This is the kind of problem we’re going to run into.”

Global Imbalances and Other Risks

According to Allen, a second major problem that goes unaddressed by the legislation is the continuing rise of global financial imbalances, which he notes are increasingly problematic. Correcting these imbalances would involve complex, highly charged negotiations on an international scale, such as reform of the International Monetary Fund or rethinking U.S. relations with China.

In addition, Allen finds recent Fed moves toward quantitative easing risky. “But they don’t think that at the Fed. They have put in people who think the same way. We need to have mechanisms that can deal with differences of opinion and not pack these bodies with people who think the same way.” Allen suggests the creation of an independent body, funded perhaps through an endowment, with members who serve long tenures and have the authority to question whether the Fed is moving in the right direction.

The new reform package also calls for the creation of exchanges to trade financial derivatives, which would provide greater transparency to financial markets. “I definitely approve of putting [derivatives] on exchanges and having better prices,” says Siegel, who adds that these products are “absolutely essential” in modern finance. “The problem wasn’t the derivatives. It was the fact that the regulators didn’t know who had them and didn’t know the prices.”

Kent Smetters, a Wharton professor of insurance and risk management, also is positive about the new plan to trade derivatives on third-party exchanges and clearinghouses. He notes that because these types of exchanges typically accept the risk of default, they will have incentives to manage the risk correctly. “This approach is much smarter than some government bureaucrat trying to risk-manage specific deals or enforcing a one-size-fits-all approach.”

According to Wharton management professor Raffi Amit, the reforms add new transparency to the financial system and reduce possible conflicts of interest. Overall, he is optimistic about the Dodd-Frank Act, but he notes that the law could backfire if it is not implemented correctly. For example, he says, increased capital requirements for financial institutions make the system safer, but he also warns of a “flip side.” If regulations are too tight, they might prevent banks from lending during an economic crisis, which is precisely when they would be called on to help stimulate spending and investment. He notes that today’s large financial institutions, such as Goldman Sachs and J.P. Morgan, are complex “supermarkets of financial services” that are extremely difficult for regulators to supervise. “But I am pleased with the direction that financial regulations are taking us. Some people say it is too little too late. I say better late than never.”

Waiting ‘an Eternity’

Wharton finance professor Mauro Guillen also supports the major intentions of Dodd-Frank, but points to two main problems with the reforms. His first concern is that many of the changes are not expected to be fully enacted until 2015. “That is awkward,” he notes. “Five years is an eternity for financial markets.”

His second worry is about the approach to managing systemic risk through the oversight council. “I wonder whether such a council will be effective or whether it would be better to give an agency, such as the Fed, full power.” He acknowledges that Congress wanted to add more oversight to the financial system because the existing institutions failed to prevent the most recent recession. However, he suggests that creating a new entity adds another layer of complexity that could create new, unintended problems. “It would be better to have just one interlocutor in this setting so that information exchange and decision-making could take place on a more timely basis.”

Wachter notes that the bill does not address reforms in the housing finance system which was a major cause of the financial meltdown. “We can talk about the banking bill but it says nothing about Fannie Mae and Freddie Mac. The legislation does a huge amount, but it also does not do a huge amount.” She adds that it is not clear who would be left on the hook to pay for unwinding a major institution. It will be difficult to simply put a major financial player out of business without unleashing a liquidity crisis that could again cripple the broader economy. “In the face of a crisis of this magnitude, there will be intervention on a large scale,” Wachter predicts. “It cannot be a simple resolution overnight when indeed all financial entities are in a net of destruction with a liquidity crisis.”

The key to preventing future crises, Wachter argues, is systematic provision of information to markets — an approach that has yet to be developed as part of the financial reform package. The roots of the current economic collapse lie in shadow banking systems and involve securities that were rated by agencies that did not have the correct incentives to become well-informed about the realities of the overall market, she says. “We need to replace opacity with transparency. It is the intent to do so in the legislation, but how we get there is a work of not months, but years.”

Smetters questions whether the restrictions on proprietary bank trading will be enforceable. “It will be very hard to know when a bank is truly trading for its own profit or trying to mitigate some of the risk it accepted from a client,” he points out. It was a “horrendous mistake,” he adds, to exempt the insurance industry from the consumer anti-fraud provisions of the law. While there are many good insurers with solid products, there are others that embed their offerings with large, hidden fees, improper labeling, “fancy language” and other obstacles to consumers, he notes. “As a nation, we need to finally come to the realization that insurance should no longer be regulated at the individual state level. It is a clear interstate commerce concern, and there are enormous economies of scale from centralizing and coordinating regulation at the federal level.”

Issues of Reach and Scale

Several faculty members express concern that the proposals called for in Dodd-Frank will be limited in their effectiveness because they apply to only one nation in what is now a fully integrated international economy.

And regarding what would be a key issue in any reform effort, Allen points out that provisions designed to avoid the problem of financial institutions that are “too big to fail” will fall short of having any effect on the institutions that are the primary targets — such as Citigroup, Bank of America or J.P. Morgan. “These all have massive international footprints and I don’t think [U.S. regulators] are going to be able to use their powers [with regard to] these firms because the international aspects have not been dealt with in a convincing way.”

Wachter agrees that the legislation should be coordinated across nations. For example, she notes financial markets have entered a “new world” with full interplay between the housing sector and international capital flows, she says. “This all has to be harmonized. It won’t work if the U.S. goes one way and Europe goes another.”

Guillen notes that many other countries also are reflecting on how to address weaknesses in financial systems with the aim of avoiding another major economic collapse. “At the end of the day, coordination is necessary. It will be very difficult for any country to enforce these new regulations without [it].”

Reflecting on Wolin’s speech, Wharton finance professor David Wessels thinks the Treasury Department’s coordinated presentations are a good way to lay the groundwork for developing specifics of the rules. However he says at this point they remain “light on substance.” Wessels questions, for example, whether short-term lenders would be protected in a bank default. He also wonders whether a fee assessed on other financial service firms to cover a failed company — as suggested by Wolin — would work at a time when other large banks are likely to be facing major problems, too.

Wessels says he is surprised by Treasury’s emphasis on consumer protection when so many other major structural issues in the global financial framework need to be addressed. “The administration is using the Dodd-Frank legislation to remind the American people about its efforts to restart the economy. Through these talks they want the voter to believe they are getting things done, even at the structural level.”

Amit suggests that the speech shows the administration is “headed the right way,” yet it remains to be seen whether the final language and regulatory structure reflect the spirit of Dodd-Frank. “As they say, the devil is in the details.”