Toomey Tackles TBTF
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 a real issue: 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 financial crisis.

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.