Dodd-Frank and too big to fail receive too little attention

Reuters

Commuters are reflected in stone as they walk past the JP Morgan headquarters in New York May 22, 2012.

Article Highlights

  • The Dodd-Frank Act-another of Obama's major initiatives-has managed to skate by with little adverse commentary.

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  • Under #TBTF, large firms look less risky than their smaller competitors and are rewarded with lower funding costs.

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  • Dodd-Frank sets up a resolution system that enables the government quickly to bail out creditors if the firms fail.

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When, in the first debate, Mitt Romney referred to the Dodd-Frank Act as "a big kiss" for the Wall Street banks, he opened a discussion that has received too little attention in this election season. Most voters oppose ObamaCare, and the stimulus is so unpopular that President Obama doesn't even mention it in his campaign. But the Dodd-Frank Act-another of Obama's major initiatives-has managed to skate by with little adverse commentary.

With his remark, however, Romney highlighted the fact that Dodd-Frank permanently embeds in U.S. law the idea that certain large firms are the too big to fail. In a too-big- to-fail environment, moral hazard thrives; creditors and other investors believe that the government will act to prevent the largest firms from failing-and, if they fail, prevent creditor losses.

In other words, too big to fail makes these large firms look less risky than their smaller competitors and rewards them with lower funding costs. As Ben Bernanke has observed "a bank which is thought to be too big to fail gets an artificial subsidy in the interest rate that it can borrow at." Over time, this will impair the competitiveness of the U.S. financial system, reduce market discipline, and increase industry consolidation as smaller firms are compelled to sell out to their larger rivals.

Indeed, the key provisions of the Dodd-Frank Act seem designed to reassure creditors that the largest firms will not be allowed to fail. First, the act declares that bank holding companies with assets greater than $50 billion- a total of 36 firms-are a "potential threat to the stability of the United States financial system" if they fail. On its face, this is a statement by the government that these banking organizations are too big to fail.

In addition, the Financial Stability Oversight Council, an uber regulator established by the act and headed by the Treasury secretary, is empowered to designate certain nonbank financial institutions-insurance companies, finance companies, hedge funds, financial holding companies and others-that would also pose a threat if they fail.

All these firms are turned over to the Federal Reserve for what the act calls "stringent regulation," thus assuring creditors that the risk-taking of these firms will be tightly controlled. This might be anathema for shareholders, who hope for profits, but it is alluring for creditors, who get no benefits from risk-taking.

Finally, if failure nevertheless occurs, the act sets up a resolution system that enables the government quickly to bail out creditors. Dodd-Frank authorizes the secretary of the Treasury to seize any financial firm in danger of failing if he believes that its failure will create instability in the U.S. financial system. If the firm objects, the secretary can ask a court to determine the reasonableness of the seizure, but the court has only one day to make its decision. If it doesn't act in that day, the firm is remitted to the FDIC for resolution "by operation of law." No stays or appeals are allowed, and it is a felony for anyone to disclose that the secretary has sought court approval.

The reason for this rush to judgment is reasonably clear: the drafters of the act wanted to put in place a mechanism that would allow a quick bailout of creditors before a run occurs. This was confirmed in a recent statement released by Representative Barney Frank, one of the eponymous drafters of the act. Describing the powers given to the FDIC, the statement notes that "the rules allow the FDIC to pay some unsecured creditors more than others similarly situated, or pay some unsecured creditors more than the liquidation value they would have received in bankruptcy." This is the same fraught policy the FDIC has often followed in the past-paying off uninsured depositors in order to prevent runs when a failing bank is closed.

Dodd-Frank has now extended this policy to creditors of all large financial institutions, including the largest bank holding companies singled out by Romney and the large nonbank financial institutions that the FSOC may designate in the future. A misplaced policy that was once confined to banking alone will now be extended to the entire financial system.

As long as the Dodd-Frank Act remains on the books, large firms will have a funding advantage over their smaller rivals. Recognizing this, many commentators have proposed to break up the biggest banks.

But this does not pass a cost-benefit test. We don't have any idea what size would make a bank not too big to fail. If JP Morgan Chase were broken into ten pieces, each would be more than $200 billion, and still-according to Dodd-Frank-a threat to the stability of the financial system.

In addition, U.S. companies operating around the world would have to find new sources of short-term liquidity, payroll processing, trade finance, and market expertise; the market for government and private debt securities would lose liquidity as the principal market-makers backed off; and financial institutions and end-users of all kinds would find their principal source of risk-management for credit, currency and interest rate risk had disappeared.

As things stand now, we have few good choices, but repealing the too big to fail provisions of Dodd-Frank-which Romney implied he will do-would be an excellent start.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.  His book, "Bad History, Worse Policy: How a False Narrative About the Financial Crisis Gave Us Dodd-Frank" will be published in January.

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