If You Liked Fannie and Freddie . . .

Think ObamaCare for the financial system. That's one way to understand Sen. Chris Dodd's bill to reform financial regulation. If passed in its current form, the bill would give the government control over the financial system in roughly the same way, and to the same extent, that ObamaCare would take over the nation's health care. There isn't a public option, exactly, but the private firms involved would be so heavily regulated that they would be effectively controlled by the government.

The threat comes primarily from the new powers granted to the Federal Reserve and a new regulatory grouping called the Financial Stability Oversight Council (FSOC). Although the Fed failed to anticipate the financial crisis, missed the significance of the developing housing bubble, and did not prevent our largest banks from taking excessive risks, it is rewarded in the bill with authority to control the rest of the financial system.

Not only will the Fed retain its regulatory authority over banks and bank holding companies with assets of more than $50 billion, but the FSOC will be authorized to place under the Fed's supervision any other large nonbank financial institutions--insurance companies, securities firms, finance companies, hedge funds and others--that the FSOC believes could "pose risks to the financial stability of the United States."

Although the Fed failed to anticipate the financial crisis, missed the significance of the developing housing bubble, and did not prevent our largest banks from taking excessive risks, it is rewarded in the bill with authority to control the rest of the financial system.

The Fed's authority over all these firms will extend to setting standards for capital, liquidity, leverage and risk management. If this isn't enough to remove the threat to U.S. financial stability, the Fed may order a company to terminate one or more activities, impose conditions on how the company operates, or require the company to sell or transfer assets to unaffiliated parties.

It's easy to imagine how these extensive authorities confer practical control over every policy and every action of the firms that come under the Fed's supervision. The innovation and risk taking that have always characterized the American financial system will be stifled beneath the Fed's bureaucratic blanket. The center of gravity of the U.S. financial system will move to Washington, where large firms will have to go hat in hand to gain Fed approval for every significant move. Moreover, by designating these firms as potential threats to financial stability, the bill clearly identifies them as too big to fail. This will ensure their competitive survival since it's unimaginable that the Fed will allow them to fail while under its control.

Although Sen. Dodd apparently believes that the only significant question about too big to fail is whether taxpayer money is used to bail out a large firm, this is far from true. The real significance of the too-big-to-fail designation, as every small banker knows, is that the implicit protection of the government confers a lower cost of funds and thus significant competitive advantages.

We've seen this movie before, and it wasn't pretty. Fannie Mae and Freddie Mac were too big to fail, and their lower cost of funds allowed them to drive all competition from the part of the secondary mortgage market where they were allowed to operate. They grew to multitrillion dollar size and took multitrillion dollar risks. Some time in the next few years, American taxpayers will receive a bill for more than $400 billion to clean up the losses that are now baked in the Fannie and Freddie cake.

Designating large nonbank financial companies as too big to fail will be like creating Fannies and Freddies in every area of the economy. Their lower cost of funds--stemming from their implicit government protection--will allow them to out-compete smaller firms. Gradually, our competitive financial markets will consolidate into markets dominated by a few big firms. Smaller firms and better business models will not be able to compete their way to the top because the larger ones will enjoy government backing and protection. This is the dystopian future that awaits the American economy if Sen. Dodd's financial ObamaCare is ever enacted.

Unfortunately, there is more. Not only does the Dodd bill establish too big to fail as national policy, but it makes the idea real by creating a system for bailing out large financial companies if they get into trouble. Of course, "bailing out" is not the phrase used in the bill; the preferred language there is "orderly liquidation," and indeed the bill requires that any firm taken over by the government--the FDIC is the preferred receiver--be liquidated rather than returned to health.

But this, once again, misses the forest for the trees. From the perspective of its effect on the economy, it does not matter what happens to the company, or to its shareholders and management. The only thing that matters in a government resolution of a failing company is what happens to the creditors--because it's the creditors that will provide the funds preferentially and at favorable rates to large companies rather than small ones.

In this respect, the Dodd bill does it again--it signals to creditors that they will get a better deal if they lend to the big regulated firms rather than their smaller competitors, and it does this by making it possible for creditors to be fully paid when a too-big-to-fail financial firm is liquidated, even though this would not happen in bankruptcy. There are a number of ways that this can be done, including through a simple merger with a healthy firm. As a prescription for moral hazard, this can hardly be surpassed. The creditors will line up to provide cheap money to the too-big-to-fail firms the Fed will be regulating.

This bill, like its health-care analogue, is an unnecessary rush to judgment. In May 2009, Congress created the Financial Crisis Inquiry Commission, a 10-member group assigned to find and report on the causes of the financial crisis. (Full disclosure: I am a member of the commission). Despite the fact that it set up a commission to tell it what happened, Congress has been rushing to legislate as though it already knows.

The Dodd bill, like the bill that has already passed the House, assumes that the financial crisis was caused by insufficient government regulation. It would be surprising if the American people believed that--having noticed that the banks are heavily regulated but still got into serious trouble--but there is no question that this fits well with Washington's needs.

The commission's deadline for reporting is Dec. 15, 2010. Doesn't it make sense to hear the diagnosis before enacting the prescription?

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.

Photo Credit: spakattacks/Flickr/Creative Commons

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