Illustration by Bloomberg View
Illustration by Bloomberg View

More than three years after the U.S. financial system went into free fall, the Dodd-Frank Act, Congress’s primary effort to prevent a repeat episode, has become something of a bete noire.

Executives at big banks say the law will bog them down in costly regulations. Republicans want to repeal it. Presidential hopeful Newt Gingrich even suggests jailing its authors, Representative Barney Frank and former Senator Chris Dodd.

The vilification of Dodd-Frank is odd, given that most of the law has yet to take effect. The law firm Davis Polk & Wardwell LLP estimates that as of Dec. 1, only 74 of the 400 required rules had been finalized, and 154 had missed the law’s deadlines.

Most people, quite understandably, haven’t had the time or patience to wade through the law’s 848 pages. As a service to them, we did so. What we found, admittedly cloaked in eye-glazing language, was an elegant core of sensible ideas. Consider it a fail-safe system with three levels of containment.

Level 1 is designed to make disastrous mistakes at financial institutions less likely. One central element is transparency: Bank stress tests, centralized reporting of derivatives trades and a data-analysis arm called the Office of Financial Research will give regulators, investors and journalists more information. They can use it to identify dangerous concentrations of risk in banks, investment firms, insurers and other financial entities.

The law also rearranges some incentives. By stipulating that lenders must hold a portion of the mortgages they originate, Dodd-Frank reduces the temptation to make bad loans and sell them off to greater fools. By forbidding federally insured banks from engaging in speculative trading for their own accounts, the so-called Volcker rule limits a taxpayer subsidy that has encouraged traders at such banks to take outsized risks. By requiring executives to write credible living wills describing how their institutions can be dismantled in bankruptcy, the law leans against banks getting too large or too complex to manage.

Level 2 aims to make financial institutions better able to survive when mistakes do happen. The crucial piece here is higher capital requirements. Like equity for a homeowner, capital allows a bank to stay solvent if the value of its investments falls.

Stress tests conducted by the Federal Reserve play a role, too. By simulating how a bank would fare in worst-case scenarios, they help ensure that banks don’t report fictitious capital. The Volcker rule, for its part, helps limit trading losses, which tend to eat into capital precisely when banks need it most.

Level 3 seeks to make sure that if a financial institution does fail, it won’t bring down the whole system. The law gives the Federal Deposit Insurance Corp. the power to take over a troubled institution and wind it down in a way that limits contagion -- a task made easier by living wills and better information on how financial institutions are linked.

In derivatives markets, banks, hedge funds and other players must put up enough collateral to pay off their immediate obligations if they run into distress. That reduces the chances that a large, complex institution can wreak the kind of havoc that Lehman Brothers Holdings Inc. and American International Group Inc. did in 2008.

Dodd-Frank contains many more rules, some unnecessarily burdensome. But bank executives such as JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon have aimed their criticism largely at the new capital requirements and the Volcker rule. Although potentially bad for bonuses, those are among the provisions that promise the greatest net gain for the broader economy.

Researchers at the Bank of England, for example, have found that even if capital levels were more than doubled, the economic benefit of averting financial crises would outweigh any costs that might arise. The U.S. Office of the Comptroller of the Currency concluded that the incremental cost of the Volcker rule’s requirements to track and report proprietary trading would be only $50 million a year, because banks already do most of it (or should). Compared with the estimated $15.8 billion the top six U.S. banks lost on proprietary trading during the last crisis, that seems like a good deal.

The OCC also estimates that the Volcker rule’s hedge-fund investment provisions would require some banks to raise extra capital at a total cost of $917 million a year -- an added buffer that, according to the Bank of England research, would more than pay for itself.

The law leaves some important business unfinished. It doesn’t address money-market mutual funds, whose advertising and promotions suggest that investors will get back at least a dollar for every dollar put in, even as the funds are heavily invested in Europe and hence vulnerable to the region’s debt crisis.

Nor does Dodd-Frank deal with the high-frequency trading that contributed to last year’s flash crash. And it does nothing about Fannie Mae and Freddie Mac, the mortgage financiers that have so far cost taxpayers more than $150 billion.

Dodd-Frank deliberately lacks a Level 4: It forbids the use of taxpayer money to bail out institutions whose failure could bring down the system. This makes sense given the dire state of the government’s finances, but it’s also dangerously wishful thinking now that the largest U.S. banks are even bigger than they were in 2006. Until the curbs in Dodd-Frank have had time to reverse that trend, and unless international regulators reach agreement on how to wind down multinational institutions, it’s hard to imagine how the FDIC could safely liquidate a Bank of America or a Citigroup.

The solution is not to repeal Dodd-Frank. It is to construct its containment system as quickly as possible. The uncertainty over how the law should be implemented is probably its greatest flaw. The sooner rules are written and enforced, the sooner banks can learn to live with them and get on with the business of helping the economy grow.

To contact the Bloomberg View editorial board: view@bloomberg.net.