Too big to ignore: The future of bailouts and Dodd-Frank after the 2012 election

Gary Yim / Shutterstock.com

Article Highlights

  • The Dodd-Frank Act fails to achieve what should have been its principal objective

    Tweet This

  • Dodd-Frank regulation compounds moral hazard problem in the financial system

    Tweet This

  • Dodd-Frank ensures largest institutions will continue to benefit from implicit government support

    Tweet This

 

Subscribe to AEI's Financial Services emails.

In the first presidential debate, Mitt Romney identified the Dodd-Frank Act as the “biggest kiss” to Wall Street, opening a topic that has received too little attention in this election season. Supporters of the act argue that it ends bailouts, but this is true only if bailouts are defined narrowly as the use of taxpayer funds to rescue a failing financial institution. However, the source of funds for a bailout is not the real issue. The possibility of a creditor bailout creates moral hazard, no matter where the bailout funds originate, and it is moral hazard that provides the larg-est banks or other large financial firms with competitive advantages. The same is true of the special “stringent” regulation required by the act for banks and other firms deemed systemically important.These provisions create moral hazard by reassuring creditors that there is less risk in lending to these large firms than to small ones, and thus provide the biggest firms with a continuing competitive advantage in the form of lower funding costs. Romney is correct to see this as a subsidy to big banks and other large financial institutions. Title I invokes stringent regulation for systemically important firms, Title II provides a mechanism for bailing out creditors if a systemically important firm should fail, and Title VIII authorizes Federal Reserve funding for an unlimited number of additional financial institutions. If President Obama is re-elected, Dodd-Frank is likely to continue in its current form, adding materially to the problem of moral hazard and TBTF in the US financial system.   

Key points in this Outlook:

  • In the first presidential debate, Mitt Romney highlighted the competitive benefits that the Dodd-Frank Act creates for large financial institutions, an issue that has been largely ignored in election-related discussions.
  • Although the Dodd-Frank Act was advertised as eliminating financial bailouts and “too big to fail,” the act creates these and other competitive benefits for large financial firms.
  • Over time, these advantages will enhance the growth of large financial firms at the expense of smaller ones, encouraging unnecessary industry consolidation, stifling creative destruction by innovative small firms, and fostering crony capitalism.


At its enactment, the Dodd-Frank Act (DFA) was advertised as legislation that would end financial bailouts. When signing the legislation on July 21, 2010, President Obama said, “There will be no more tax-funded bailouts  —  period.”[1] But this is an accurate depiction of the act only because the president and the act’s other proponents define bailouts as the use of public funds for rescuing failing financial institutions.

This definition, however, is too narrow. The troubling element of bailouts is not where the bailout funds originate — although taxpayers are right to complain — but the moral hazard effect of using them to protect the creditors of firms considered too big to fail (TBTF). By fostering moral hazard — the perception among investors and creditors that lending to large firms is a safer bet than lending to small ones — the act provides large institutions with funding advantages over their smaller rivals. Over time, these advantages will force unnecessary industry consolidation, stifle creative destruction by innovative smaller firms, and foster crony capitalism.

Since the funding advantages are another expression of the same moral hazard that flows from taxpayer-financed bailouts, anything that contributes to the TBTF status of the largest financial firms should be seen as a continuing bailout.[2] That’s why, in the first 2012 presidential debate, Mitt Romney referred to Dodd-Frank as “the biggest kiss” for the largest Wall Street banks.

It is widely accepted that financial firms receive valuable benefits resulting from the perception that they are TBTF. Federal Reserve Chairman Ben Bernanke has observed that “a bank which is thought to be too big to fail gets an artificial subsidy in the interest rate that it can borrow at.”[3]  In an influential 2010 paper, Andrew Haldane, the Bank of England’s executive director for financial stability, calculated that the subsidy to the biggest global banks, based on the perception that they will not be allowed to fail, was about $250 billion in 2009 alone.[4] Simon Johnson of the Massachusetts Institute of Technology, in his book 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, observed that “a vague expectation that the government would bail [the biggest banks] out in a crisis has turned into a virtual certainty, lowering their funding costs relative to their smaller competitors.”[5] And Representative Ed Royce (R-CA), a senior member of the House Financial Services Committee, has noted,

The largest institutions will continue to benefit from the implicit government support, which translates into lower borrowing costs . . . which economists say ranges from 70 basis points to over 100 basis points. . . . [E]xperts have speculated that the number of small institutions will be halved over the next decade because they do not benefit from the perceived government backstop implicit in Dodd-Frank.[6]

Indeed, a small Texas bank has launched a constitutional challenge to the DFA on just this point, arguing that the act’s designation of banks that are $50 billion or larger as systemically significant is unconstitutional because it creates an uneven competitive environment.[7]

The DFA contains several provisions that offer the same benefits to large firms that would arise from a routine government policy of rescuing financial institutions that are TBTF. In this sense, the act fails to achieve what should have been its principal objective: protecting the competitive financial system by eliminating both bailouts and TBTF, and the moral hazard they create.

Title I: Large Financial Institutions Are Declared Too Big to Fail

Title I of the DFA requires “stringent” regulation of all banking organizations with $50 billion in assets or more because their failure could cause “instability in the U.S. financial system.” Thirty-six bank holding companies are currently in this category. The signal that this sends to creditors is unambiguous: the government has judged that any banking organization of this size is a threat to the stability of the US financial system and is thus TBTF.

"The Dodd-Frank Act fails to achieve what should have been its principal objective: protecting the competitive financial system by eliminating both bailouts and TBTF, and the moral hazard they create."
The logical consequence is that the government will take special steps to prevent failure and special actions if failure nevertheless occurs. The special steps to prevent failure are detailed in Title I of the DFA; the special actions when failures occur are described in Title II, discussed in the next section.

What exactly the act’s drafters meant by “stringent” regulation (the statutory term) is not clear, but it is clear that the Fed has been directed to give these organizations special regulatory attention to prevent their failure. Indeed, the Fed has already published a proposed regulation that details the special restrictions that will be imposed on these institutions.

It is questionable, of course, whether greater regulation will effectively keep these institutions from failing, but at the margin creditors will certainly feel more assured in lending to firms that are stringently regulated by the Fed than those that are not. When financial institutions are heavily regulated, they are likely to take fewer risks; although this will be bad news for shareholders, who are interested in profits, it is good news for creditors, the only group who does not benefit from risk taking. Other banking organizations that are not stringently regulated will likely be taking more risks and thus will be charged appropriate risk premiums by their creditors, putting them at a competitive disadvantage. This entrenches the unlevel playing field that, as I have outlined, is destructive to competition in the banking industry.

 Title I also authorizes the Financial Stability Oversight Council (FSOC), an agency consisting of all the federal financial regulators and headed by the secretary of the Treasury, to designate certain nonbank financial firms — insurance companies, financial holding companies, finance companies, securities firms, hedge funds, and others — as systemically important because they, too, could create instability in the US financial system if they fail. Recent news articles have indicated that MetLife, Prudential Insurance, AIG, and GE Capital are all in the FSOC’s sights for designation.[8] Once these firms are formally identified by the FSOC, they, like the largest banks, will be seen as TBTF and will gain the benefits of lower-cost funding vis-à-vis their smaller competitors.  In some cases, the benefits will be even greater; imagine how the largest insurers will be able to use their TBTF designation to impress clients with their long-term stability.[9]

Thus, Title I creates the continuing subsidy of moral hazard and lower-cost funding as effectively as a tax-payer bailout — not only for banking organizations that are already considered TBTF, but also for the nonbank financial institutions that the FSOC will designate as systemically important in the future. However, as I will discuss in the next section, Title II of the DFA also creates moral hazard by encouraging creditors to believe that the Federal Deposit Insurance Corporation (FDIC) will treat them more favorably than a bankruptcy court.

Title II: Bailouts and the Orderly Liquidation Authority

Title II of the DFA creates what is called an Orderly Liquidation Authority (OLA). Under its provisions, the secretary of the Treasury, in consultation with the chairmen of the FDIC and the Fed, may seize any financialfirm (not just one deemed systemically important) if he believes its failure might cause “instability in the US financial system.” If the board of directors of the firm objects, the secretary is authorized to seek a court order to compel the firm’s compliance. The court has one day to decide whether the secretary’s seizure decision is reasonable. If the court fails to act during that period, the firm is turned over to the FDIC for liquidation “by operation of law.” No stays or appeals are permitted.

Once it gains control of a failing firm, the FDIC has authority to bail out the firm’s creditors. It can transfer all the assets of the firm into what is called a bridge financial institution, along with whatever liabilities it chooses. This allows the agency to select which creditors it wants to favor by paying them off and which, if any, will take losses. The likelihood is that, to prevent destabilizing runs, the short-term and unsecured creditors will be at the top of the list.

This is the first step in a bailout and the beginning of the moral hazard problem. That the FDIC was intended to have this power is freely admitted in a statement put out by the minority (Democratic) staff of the House Financial Services Committee in its analysis of the OLA on October 16, 2012. This release, on behalf of Representative Barney Frank (D-MA), one of the principal drafters of the act, notes that the “rules allow the FDIC to pay some unsecured creditors more than others similarly situated, or to pay some unsecured creditors more than the liquidation value they would receive in bankruptcy . . . only for the purpose of minimizing receivership losses or enabling the continuation of functions essential to the receivership.”[10]
"If the FDIC bails out creditors with the funds it ultimately acquires by taxing other large financial firms, it has still created moral hazard."
With this power, among many others, in the hands of the FDIC under the act, it is no wonder that creditors see the OLA as a bailout vehicle. It is almost always true that when a regulatory agency has the power to bail out creditors it will do so, especially if the alternative is a market disruption for which it will be blamed.

To provide the necessary funds for a bailout, the DFA authorizes the FDIC to borrow as much from the Treasury as it needs, up to 100 percent of the value of the unencumbered assets of the failed firm that were transferred to the bridge institution. Thus, secured creditors, and possibly even unsecured creditors, can be paid in full. But this does not mean that the taxpayers will bear any losses. Under the DFA, any losses arising out of these transactions can be made up by assessing other large systemically important financial institutions. Although no taxpayer funds will be used in this activity, the FDIC is free to spend as much as it wants to protect creditors.

Proponents of the DFA claim that these and other provisions of the act eliminate both bailouts and TBTF. Bailouts are eliminated, they argue, because the tax-payers will not be required to pay for any of the costs of resolution. As we have seen, however, the key policy issue associated with bailouts is moral hazard, not the source of the funds; if the FDIC bails out creditors with the funds it ultimately acquires by taxing other large financial firms, it has still created moral hazard.

Similarly, proponents of the act argue that the OLA eliminates TBTF because it enables regulators and government officials to resolve a failing financial firm without fear that the firm’s failure will cause the kind of panic that occurred in the wake of the 2008 Lehman Brothers bankruptcy. In other words, the OLA has attributes that make its resolution materially different from a bankruptcy. This notion, however, is based on two faulty premises.

The first is the idea that the OLA process will prevent the kind of panic that followed the Lehman bankruptcy. This wholly misconstrues why that panic occurred. By 2008, most major financial institutions were heavily invested in mortgage-backed securities, often based on subprime mortgages. When the housing bubble began to deflate in 2007, these securities lost much of their value, inflicting significant losses on these firms under the mark-to-market accounting rules that then prevailed and reducing their capital and liquidity.

When Lehman failed, creditors of and investors in other firms that had also invested in mortgage-backed securities began to fear that they too might suffer losses and rushed to withdraw what funds they could from other financial institutions. This induced the hoarding of cash by banks and others — anxious about their ability to meet customer withdrawal demands — and resulted in an unprecedented refusal by banks to lend to one another. This phenomenon, where many financial institutions are simultaneously weakened by the sudden decline in the value of a widely held asset — in this case, mortgage-backed securities — is known to scholars as a “common shock.”[11] It was this common shock that that caused the 2008 financial crisis and panic.[12]

This result would not have been different if the OLA had existed when Lehman failed, and instead of filing for bankruptcy the firm had been seized by the secretary of the Treasury and turned over to the FDIC for liquidation. The effect on the market would have been the same: the resulting common shock would have induced investors and short-term creditors to withdraw their funds from similar firms, causing banks and others to hoard cash.

Thus, it is wrong to believe that the OLA would eliminate or even mitigate the TBTF problem. The fact is that where a common shock has affected the market’s perception of the stability or solvency of a large number of financial institutions, the seizure of a single firm by the secretary of the Treasury would produce the same panic reaction as a bankruptcy filing. In that case, the OLA would not be an improvement on an ordinary bankruptcy; regulators would still fear that the seizure of a large financial institution would create a market meltdown. That, in turn, would induce them to seek a quick bail-out in which the principal creditors are rescued. The fact that creditors already anticipate this outcome is what causes the moral hazard that remains at the root of the problem.

Second, there is still the question of whether the result would be the same if a large financial firm failed at a time when the market was not susceptible to a common-shock reaction — when financial institutions are generally considered by investors and creditors to be healthy and stable. Could a bankruptcy filing by a large firm create a panic in these circumstances, inducing regulators to bail out the creditors of the failed firm? Ironically, events surrounding the Lehman failure shed some light on this question. With the exception of one money market mutual fund that was unable to maintain the value of its shares at one dollar, no other financial firms were significantly and adversely affected by Lehman’s inability to meet its financial obligations.

In other words, when the market is generally stable, there is no need to bail out a large institution like Lehman; because it will not drag down others, its failure will not cause a market panic. Thus, it seems likely that if a large financial firm fails when the market is stable, we would not need the OLA or any other government resolution system that can bail out creditors. The bankruptcy system — which does not create moral hazard because it does not offer special benefits to creditors — would be sufficient.

Accordingly, the OLA stands as another example of the bailout potential created by the DFA. It would not prevent a panic in the face of a future common shock, and it would not be necessary to prevent a panic if a large financial firm fails in the absence of a common shock. Instead, by establishing a mechanism with which the government can
rescue the creditors of large firms, the OLA creates moral hazard and the continuing bailouts that benefit large financial institutions.

Titles VII and VIII: Fed Backing for Clearinghouses and Financial Institutions

Before the DFA was enacted, most derivatives contracts were written between banks and their customers or between banks and other banks (as risks absorbed from customers were redistributed across the banking system). Payments flowed through this network of trading partners based on the terms of these bilateral contracts, but banks also used clearinghouses as intermediaries forrisk-management purposes — particularly where a counterparty’s financial position might be weak.

Title VII of Dodd-Frank now requires that most swap transactions be cleared through an independent clearinghouse. For example, assume that Bank A and Bank B have entered into an interest rate swap. They have agreed to exchange payments based on a hypothetical, or “notional,” amount of $10 million. Bank A agrees to pay a fixed 5 percent interest rate on the notional amount to Bank B, and Bank B agrees to pay a floating rate of interest on the notional amount to Bank A based on a spread over the market rate for the Treasury’s 10-year note. Thus, whenever the spread over the Treasury note results in a market rate of more than 5 percent, Bank B pays the difference to Bank A, and when market rate falls so that the floating rate is less than 5 percent, Bank A pays the difference to Bank B. This contract might last 5 or 10 years. Agreements like this also cover currency and credit derivatives, but the simplest version is the interest rate swap.

Before Dodd-Frank, Bank A and Bank B might have exchanged these payments on their own, but after Dodd-Frank they are required to engage a clearinghouse as counterparty between them, receiving payments from one and transferring them to the other. Under these circumstances, clearinghouses will be required to handle many trillions of dollars more in derivatives transactions than in the past. When it acts as a central counterparty, the clearinghouse assumes the obligation to make the payments that each party has promised the other under their contract, and it takes the risk that one party will not perform on its obligation. If that happens, its risks are normally covered by collateral placed with the clearinghouse by its members, who may be the actual parties to a trade, like Banks A and B, or representatives of those parties.

Sometimes, however, failures to pay by either buyers or sellers are so great that they exceed the collateral posted by the clearinghouse member that is or represents the defaulting party. In that case, the clearinghouse has the right to collect its losses from the member that defaulted, as well as from the collateral and assets of the other clearinghouse members that have been pledged or paid to protect against this risk. In the event of a large-scale financial crisis, all these resources might be insufficient, leaving the clearinghouse in default, with adverse consequences for those who relied on its credit. A clearinghouse default could seriously disrupt the functioning of the financial system and thus could have systemic effects.

To address this problem, which was created by Dodd-Frank’s clearinghouse requirement, Title VIII of the act authorizes the FSOC to designate clearinghouses and other financial institutions as systemically important financial market utilities and to make them eligible for the Fed’s financial support whenever they cannot otherwise meet their obligations. On July 18, 2012, the FSOC designated eight clearinghouses as eligible for this financial support.[13]
"Eventually, some or all clearinghouses will require the bailout that the Fed has been authorized to provide. In that case, the financing will come from the taxpayers." 

This policy will almost certainly impair the financial stability of the designated clearinghouses over time. Before the adoption of Titles VII and VIII, the parties to derivatives transactions, like Banks A and B, had to pay attention to the financial condition of their counter-parties; if they used a clearinghouse, they had to pay attention to the financial position of the clearinghouse to be sure that the payments to which they were entitled would actually be made. All clearinghouses, then, had to maintain strong financial positions to attract business. This is known as market discipline.

With government backing, a clearinghouse’s financial position becomes less important. Moral hazard appears again. Parties to transactions that will be cleared through a government-backed clearinghouse will be less concerned about its financial position and more concerned with other matters, such as the speed with which the clearinghouse takes on new clearing business or the fees it charges. This will reduce market discipline and foster risk taking by clearinghouses that are competing with one another to achieve greater growth and profitability. Eventually, some or all of these institutions will require the bailout that the Fed has been authorized to provide. In that case, the financing will come from the taxpayers.

Moreover, the authority to back clearinghouses does not exhaust the Fed’s ability to bail out financial institutions under Title XIII. Language in this title also permits the FSOC to declare that any financial institution engaged in payment, clearing, or settlement activity is a “designated financial market utility,” providing that institution with access to the Fed’s financial support. This appears to be a loophole that allows the FSOC and the Fed to skirt the provision in Title XI of the act, which restricts direct assistance to any financial institution under Section 13(3) of the Federal Reserve Act. Title XI specifies that any such 13(3) assistance in the future must be part of a program of “broad-based eligibility,” and then only in “exigent circumstances,” but there are no such statutory restrictions on the use of the financial support authorities in Title VIII.

Thus, although the Dodd-Frank Act was advertised as legislation that would end bailouts of financial institutions, it has authorized much more moral hazard and many more opportunities for bailouts of financial institutions and their creditors than existed under prior law. Accordingly, far from eliminating TBTF, the act increases its role in the US financial system, creating yet one more reason to repeal it.  

Notes
1. Office of the White House Press Secretary, “Remarks by the President at Signing of Dodd-Frank Wall Street Reform and Consumer Protection Act,” July 21, 2010.
2. See Peter J. Wallison and Cornelius Hurley, “Too Big to Fail Has Become a Bailout Program,” Forbes, August 14, 2012.
3. US Federal Reserve, “Transcript of Chairman Bernanke’s Press Conference, January 25, 2012, www.federalreserve.gov/mediacenter /files/FOMCpresconf20120125.pdf.
4. Andrew G. Haldane, “The $100 Billion Dollar Question” (comments, Institute of Regulation and Risk, Hong Kong, March 30, 2010), 4–5 and table 4, www.bankofengland.co.uk/publications/Documents/speeches/2010/speech433.pdf.
5. Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Knopf Doubleday Publishing Group, 2010), 12.
6. Ed Royce, “Guest Blog: Ed Royce on Dodd-Frank: One Year Later,” The Foundry, July 21, 2011, http://blog.heritage.org/2011/07/ 21/guest-blog-rep-ed-royce-on-dodd-frank-one-year-later.
7. State National Bank of Big Spring v Geithner, US District Court for the District of Columbia, June 21, 2012, http://cei.org/sites /default/files/SNB%20v%20Geithner%20-%20 Complaint.PDF.
8. Katherine Kane, “Which Nonbank FIs Are Systemically Important? FSOC Moves to Phase Three,” American Banker, October 1, 2012,  www.americanbanker.com/dodd-frank/which-nonbank-fis-are-systemically-important-fsoc-moves-to-phase-three-1053124-1 .html.
9. For more detail on this issue, see Peter J. Wallison, “Magical Thinking: The Latest Regulation from the Financial Stability Oversight Council,” AEI Financial Services Outlook (October– November 2011), www.aei.org/outlook/economics/financial-services/magical-thinking-the-latest-regulation-from-the-financial-stability-oversight-council.
10. House Committee on Financial Services, Barney Frank, Ranking Member, “Barney Frank Releases Staff Analysis of How the Wall Street Reform Law Addresses ‘Too Big to Fail,’” October 16, 2012, 5, http://democrats.financialservices.house.gov/press/PRArticle .aspx?NewsID=1493.
11. George G. Kaufman and Kenneth E. Scott, “What Is Systemic Risk and Do Bank Regulators Contribute to It?” The Independent  Review 7, no. 3 (Winter 2003): 379. See also Peter J. Wallison, “The Error at the Heart of the Dodd-Frank Act,” AEI Financial Services Outlook (August–September 2011), www.aei.org/outlook/economics /financial-services/the-error-at-the-heart-of-the-dodd-frank-act.
12. The wrong lesson has been drawn from this sequence of events. The Dodd-Frank Act is based on the idea that interconnections among financial institutions caused the panic that followed Lehman’s bankruptcy, as though others were weakened by Lehman’s default. But the interconnections theory is incorrect; the panic that followed Lehman’s bankruptcy was the result of common shock. Lehman did not drag down other interconnected firms. See Peter J. Wallison, “The Error at the Heart of the Dodd-Frank Act,” AEI Financial Services Outlook (August–September  2011), www.aei.org /outlook/economics/financial-services/the-error-at-the-heart-of-the-dodd-frank-act.
13. US Treasury Department, 2012 Annual Report, Appendix, www.treasury.gov/initiatives/fsoc/Documents/2012%20Appendix%20A%20Designation%20of%20Systemically%20Important%20Market%20Utilities.pdf.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Peter J.
Wallison

What's new on AEI

How the Common Core went wrong
image Election countdown: The mood, measurements, and mechanics
image Rubio's defense speech: Fearless, informed, and refreshing
image Sorry Kerry, there is little role for Iran in fighting ISIS
AEI on Facebook
Events Calendar
  • 22
    MON
  • 23
    TUE
  • 24
    WED
  • 25
    THU
  • 26
    FRI
Monday, September 22, 2014 | 2:30 p.m. – 4:00 p.m.
Policy implications of the new US labor market normal

We welcome you to join us as a panel of economists discuss US wage and price prospects in the coming months and the implications for the Federal Reserve’s current unorthodox monetary policy.

Event Registration is Closed
No events scheduled this day.
No events scheduled today.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.