As regular readers know, the Dodd-Frank Act is a collection of bad ideas that substitute regulators and complex regulations for transparency and market discipline.

One bad idea in the Act was the creation of the Financial Stability Oversight Council (FSOC).  Think about that name for a second.  What is the definition of “stable” for a complex, dynamic system like our financial system?

Setting aside this issue, one of FSOC’s responsibilities is to identify systemically important financial institutions (SIFIs) whose failure would cause bad things to happen.  Once these institutions have been identified, then the Federal Reserve is suppose to subject them to increased supervision and regulation.  A classic example of how under the Dodd-Frank Act regulators and regulations are substituted for transparency and market discipline.

Clearly, the goal of this additional supervision and regulation is these institutions won’t fail and bring down the global financial system (if this isn’t the goal, then why exactly would we want to designate a financial institution as a SIFI).  However, how do we know this additional supervision and regulation will succeed?  This is a very important point, because if this only line of defense doesn’t work and one of these SIFIs fails, the taxpayer is stuck bailing it out or watching bad things happen to the financial system.

Please note if we instead relied on transparency and market discipline, then it would be the investors in the SIFI and not the taxpayers who would absorb the losses from its failure.  In addition, regulators wouldn’t be prevented from subjecting the financial institution to additional supervision and regulation.  In fact, they could turn to the market for help in assessing the riskiness of the firm.  Sounds like a win-win solution.

However, relying on transparency and market discipline was not the objective of the Dodd-Frank Act.  And to its credit, everything was going along nicely until MetLife objected to being labeled a SIFI.  A judge agreed with MetLife and ordered the designation to be removed.

Supporters of the Dodd-Frank Act are upset over the ruling.

Wait a second, but why are we relying in the first place on a process where large, opaque financial institutions can either escape additional supervision or the additional supervision itself might not work to prevent a bad outcome?

The judge deserves our thanks as the ruling allows us the opportunity to rethink and get rid of the portion of the Dodd-Frank Act that deals with FSOC and SIFIs.

I realize we won’t rethink the Dodd-Frank Act.  Fortunately, the Transparency Label Initiative covers the glaring weakness in the Act when it comes to large, opaque financial institutions.

It is a matter of record these institutions won’t get a transparency label.  This greatly reduces the pool of investors for these institutions’ securities to only those who are willing and have a mandate to blindly gamble.  This in turn reduces what bad things could happen should these opaque firms fail.