Three years after the passage of Dodd-Frank – a law that was supposed to permanently end the massive publicly funded bailouts of 2008 – it’s clear that the discredited and unpopular practice of unofficially treating certain institutions as “too big to fail” is alive and well.
Under the theory of Too Big to Fail (TBTF), which was invoked during our most recent financial crisis, governmental assistance to large failing financial institutions is necessary because their failure would be catastrophic for our economy.
The idea is unpopular in part because it justifies subsidizing the very Wall Street institutions that played a part in the financial crisis. Worse yet, if TBTF stays around, big financial institutions will become riskier and risker, possibly even triggering the next major meltdown.
The evidence for TBTF’s continued existence is wide-ranging. Our financial system has become increasingly concentrated: By 2011 the five largest banks held 48 percent of U.S. banking assets, up from 30 percent in 2001. The largest bank, JPMorgan Chase, reached about 14 percent of our banking system’s total assets. The financial markets give larger banks cheaper access to credit, probably owing to the likelihood of public bailouts otherwise. One estimate found that this subsidy amounted to around $83 billion a year. Beyond that, statements by our political elite, such as Treasury secretary Jack Lew, Fed chairman Ben Bernanke, and many other policymakers, all seem to acknowledge TBTF.
TBTF helps large banks at the expense of community banks, which are essential to our economy. By making failure less common, it creates moral hazard (the subsidization of bad behavior) in our financial system.
In a normally functioning market, mismanaged firms pay more to borrow money and raise equity, because lenders demand a higher return to make up for the perceived risk. This pressure puts “market discipline” on firms because it encourages them to reduce their perceived riskiness and avoid those costs.
TBTF undermines this because investors come to believe that the government will bail out a large failed financial institution for fear of the calamitous consequences. When the possibility of loss is eliminated, a firm’s riskiness becomes essentially irrelevant to lenders.
The dynamic also gets in the way of creative destruction, the healthy economic churning brought about by failure.
These costs are widely accepted. Where opinions diverge is on what to do about TBTF. Have certain elements in Dodd-Frank effectively addressed this problem? If not, will they? Should conservatives embrace breaking up the big banks as an alternative? If not, what can we do about the problem?
Dodd-Frank’s defenders frequently cite two of its creations — the Orderly Liquidation Authority (OLA) and the Financial Stability Oversight Council (FSOC) — as a main solution to TBTF. Neither offers a sound path to ending the problem.
In short, the Orderly Liquidation Authority, under Title II of Dodd-Frank, authorizes the FDIC to set up receivership — self-funded through FDIC fees, apart from congressional appropriations — for failing financial institutions deemed to be systemically important. At least officially, these financial institutions must be liquidated.
As Columbia Law professor Thomas Merrill has explained, there is only nominal judicial or congressional oversight over the OLA, and the public won’t know about a liquidation until it’s begun. The FDIC’s new draconian power will be dictated by the rule of politics, not the rule of law (see the GM and Chrysler bankruptcies). Not only does this unaccountable power create significant economic uncertainty, it also poses real constitutional problems, which is why it’s now the subject of a legal challenge.
Of course, an unconstitutional law could still theoretically end moral hazard and TBTF, and Dodd-Frank does officially end certain kinds of bailouts. The OLA’s liquidation requirement may cause a firm’s management to avoid government assistance, and Dodd-Frank repeals statutory authorization for direct assistance to failing firms outside the OLA.
Unfortunately, Dodd-Frank’s approach to ending public bailouts does not hold up. The Federal Reserve might still be able to invoke already-existing avenues for public bailouts by facilitating mergers and sales on favorable terms, as happened during the last financial crisis.
More fundamentally, public bailouts won’t disappear with the waving of a magic legislative wand. Congress can still authorize future public bailouts, and will do so again until the political and financial elite believe that large institutions can fail without destroying our economy.
If the FDIC can be expected to implement the OLA and its liquidation requirement properly, the OLA could reduce moral hazard for some players. However, indications are that the FDIC won’t adhere to even the spirit of a “liquidation” authority.
The OLA plans for a “single point of entry” approach, which will almost certainly increase moral hazard for the subsidiaries of financial institutions. The FDIC will liquidate the institution’s parent holding company and create a bridge financial company for the remaining assets, including the company’s preserved and recapitalized critical subsidiaries. Preserving those subsidiaries will likely prevent them from experiencing any loss at all.
The Financial Stability Oversight Council does no better than the OLA at ending TBTF.
As the Competitive Enterprise Institute points out in its constitutional challenge to Dodd-Frank, Title I of the law gives the FSOC broadly defined powers to designate certain financial companies as systemically important financial institutions (SIFIs) and subject them to a tighter regulatory regime, the idea being that this reduces the likelihood that these companies will fail and demand government support.
Beyond that, the FSOC’s foundational premise — that heightened regulatory scrutiny can control systemic risk — is fundamentally flawed. Dan Balz has argued that President Obama’s weakness is for “the belief that if you could get enough smart people in a room, they could figure out a solution to whatever the problem was.” Here, his delusion is that bureaucrats can design rules to regulate TBTF out of existence.