Toomey Tackles TBTF

by Patrick Brennan
The Pennsylvania senator tries to block further bailouts.

The gargantuan 2010 Dodd-Frank financial-reform bill has a 78-page section, Title II, devoted to ending the problem of “too big to fail” financial institutions and ensuring that there’ll never be another 2008-like Wall Street bailout. But, Pennsylvania senator Pat Toomey says, Title II doesn’t do that at all: It’s a taxpayer-funded, regulator-run bailout.

After the financial crisis, virtually everyone agrees that too-big-to-fail banks — “systemically important financial institutions” — present a serious risk to the U.S. economy. Dodd-Frank, and Title II specifically, is President Obama’s and congressional Democrats’ answer to the problem, but conservatives contend that it hasn’t been solved, and may have gotten even worse.

This Thursday, the Club for Growth president-turned-senator plans to introduce a private solution: a bill co-sponsored by Texas Republican John Cornyn to replace Dodd-Frank’s bailout process with a new section of the bankruptcy code, Chapter 14, to deal with too-big-to-fail banks.

Private-sector bankruptcy, the bill’s supporters contend, avoids Title II’s cost to taxpayers and its coercive and arbitrary nature, which allows the FDIC, the federal government’s bank insurer, to set the terms of a bank’s liquidation outside the bankruptcy code.

Title II of Dodd-Frank creates an “orderly liquidation authority” that raises $24 billion from fees on financial institutions — eventually passed on to taxpayers — to provide bankruptcy financing for systemically important banks. But Toomey and other Dodd-Frank critics contend $24 billion is a CBO estimate, not a cap: Once a spigot of public funding for distressed financial institutions is installed, a much larger bailout is conveniently on tap. How much that could cost taxpayers over the long term isn’t quite clear (the 2008 bailouts cost, in the end, around $30 billion). But the federal government is explicitly on the hook to cover short-term liabilities, which could be huge.

The proposed new bankruptcy-code section, Chapter 14, explicitly bars taxpayer financing for failing banks. Instead, it would provide for a safe recapitalization by splitting the bank into two: a new, solvent “good bank” that would hold the firm’s assets and its short-term debt, and a subsidiary, controlled by the bank’s shareholders, which would hold the firm’s long-term debt. Assuming that the institution isn’t in truly dire shape and hasn’t misstated its assets and liabilities (as firms essentially did before the financial crisis), a relatively traditional bankruptcy can then proceed. To avoid wider economic shocks, the “good bank” provides certainty for stockholders and creditors, who would then take losses based on their contractual rights — as opposed to, under Title II, these allocations’ being left up to the FDIC.

Toomey argues that a reliable bankruptcy process for too-big-to-fail goes right to the heart of the problem, but financial-reform advocates on the right consider it more of a marginal improvement, which falls short of making taxpayer bailouts impossible or forcing financial institutions to be much safer.

It would create a process specifically tailored to deal rapidly and responsibly with bankruptcies that pose a systemic risk to the financial system, by, among other things, selecting expert judges and arbitrators, establishing the “good banks,” and providing a stay on certain short-term assets. This addresses real problems: A run on short-term credit was a serious problem during the Lehman Brothers bankruptcy in 2008, and the bankruptcy system wasn’t equipped for the problems the financial crisis presented.

Skeptics think the private-bankruptcy process will never be adequate for a crisis, but Toomey looks at it the other way. The FDIC, he says, is “used to rolling up small commercial banks over a weekend” and has never shown it has the ability to implement Title II. Bankruptcy law, on the other hand, has worked in the U.S. for two centuries, and courts can provide an apolitical way to adjudicate financial claims.

Some critics still object, though, that it’s not clear that newly created and specially designed bankruptcy courts will run much better, or that they’ll ever be up to the task of protecting the financial system during a crisis. Toomey argues that the creation of the “good bank” is an important stopgap that will give expeditious special courts enough time to resolve a crisis.

But all of that still leaves a serious difficulty: There’s a risk that private financing simply won’t materialize or that a firm’s losses will be catastrophic, tempting politicians to launch a taxpayer bailout to avoid the pain of a too-big-to-fail bankruptcy. Charles Calomiris, a finance professor at Columbia Business School, says statutes barring taxpayer bailouts can do only so much.

The question, he says, is whether the new “bankruptcy process is going to be reliably orderly enough that a politician sitting there is actually going to allow it to happen, rather than resort to a taxpayer-funded go-around.” An improved bankruptcy process, and statutory protections like the Toomey bill’s bar on the Federal Reserve’s providing bankruptcy financing, would help reduce that temptation.

But “suppose some government official is sitting there,” Calomiris says, “and thinks, ‘If we think that [putting a big bank through] Chapter 14 might create some economic problems, even just short-term problems, that would have political consequences for me. I might just encourage Congress to do another TARP.’ Nothing, I guess, short of a constitutional amendment, would close the door on that.”

Toomey argues that Chapter 14 could also make big banks less risky, and another TARP less likely, in the first place. The lack of an orderly, safe bankruptcy process for such firms, he says, was a gaping problem in 2008 and remains so today. With a better bankruptcy process, he argues, “the market would impose an adequate capital structure” on big banks. He points to “abundant” existing regulations on firms’ assets and liabilities, and the market discipline that would be forced on banks if their lenders knew there was no taxpayer bailout forthcoming.

The Chapter 14 proposal has been around for a while: A form of it was included in a 2009 House Republican bill (H.R. 3310) proposed as an alternative to Dodd-Frank, and the Hoover Institution has also been working on the idea for some time.

Most financial reformers take issue with the plan on the grounds that it doesn’t go far enough: Mark Calabria, director of financial-regulatory studies at the Cato Institute, calls it “one leg of a three-legged stool” that would also involve more-accountable regulation and more honest regulators. Calomiris maintains that “the path of least political resistance” to address a systemically important institution will remain some form of bailout, but says Toomey’s plan is “on the margin probably helpful.”

Some advocates, including the Hoover Institution, support implementing Chapter 14 even if it just complements, rather than replaces, Title II, because it would improve the existing bankruptcy system. In the FDIC’s eyes, bankruptcy is always the “preferred mechanism” for unwinding an insolvent firm, but no one doubts that bankruptcy law has to be improved to make it a viable solution for large financial institutions.

Calomiris, however, worries that Chapter 14 could be “a little bit of a distraction” from the central problem — the fact that banks take on too much risk and put the economy in permanent, serious danger. Financial reformers on both right and left have a lot of ideas on how to address that issue; they’re not as confident as Toomey that a private-bankruptcy process will change those fundamental incentives.

What would be Toomey’s next step to make banks stronger and safer? If we “repeal the rest of Dodd-Frank,” he promises, “they’ll have much greater flexibility — less overhead spent complying with foolish regulations,” and the ability to return to profitable lines of business that Dodd-Frank ended.

— Patrick Brennan is an associate editor at National Review.

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