The dirty little secret about the Obama administration’s “Wall Street reform” bill is that it’s full of favors for Wall Street. Case in point: You might have heard about the new $50 billion fund that would be used to wind down large financial firms that became insolvent. The fund would come from assessments on Wall Street banks, based on the principle that these “too big to fail” institutions should pre-fund their own bailouts. But you probably didn’t know that these assessments would count as tax-deductible business expenses, meaning that for every dollar the banks would pay into the fund, 35 cents would come out of the Treasury.
This provision is Senate Banking Committee chairman Chris Dodd’s financial-reform bill in a nutshell: a hodge-podge of new restrictions on Wall Street offset by a hearty dose of sweeteners to keep financial-industry cash flowing to Democrats. For every measure that would cut into Wall Street’s profits, another would subsidize its operations. New regulations governing derivatives would cut into the fees investment banks could charge for structuring these customized products. But the bailout authority awarded to the FDIC and the Federal Reserve would allow the banks to borrow at reduced rates, with their creditors secure in the knowledge that the government would step in if the market tanked.
Senate Republicans have pledged to block the bill as it currently stands. Senate majority leader Harry Reid plans to force a vote to proceed with debate today, but Sen. Richard Shelby, Dodd’s Republican counterpart on the Banking Committee, said yesterday that he expects the GOP to hang together as he and Dodd continue to work toward a compromise that can secure broad bipartisan support. There is no need to rush this process, and no need for Republicans to fear the politics of this issue so long as they are on the right side of the facts. At least four provisions need to be fixed before Republicans can vote for this bill in good conscience.
(1) The “bailout fund”: Republicans have focused a lot of firepower on the $50 billion fund mentioned above; last week the Obama administration called the GOP’s bluff and offered to drop the fund. But as we editorialized at the time, removing the liquidation fund would not address the GOP’s concerns. Under the administration’s proposal, the government would retain the power to seize and liquidate insolvent financial firms; instead of raising the necessary money beforehand, it would raise it after the fact. So the bailout fund would remain in place, except it would materialize only after a crisis — if policymakers retained the stomach to impose assessments on what would be, at that point, a very shaky financial industry.
Supporters of the Dodd bill have objected to the term “bailout fund,” arguing that the fund would be sharply restricted to liquidations, not bailouts. But it wouldn’t be. We do not dispute that the U.S. needs a better resolution mechanism for large non-bank financial firms. Bankruptcy did not appear to work well in resolving Lehman Brothers, although the heavy government intervention in financial markets both before and after it failed makes it difficult to know for sure. Even if bankruptcy would have worked better absent that intervention, the government has now set the precedent that it will step in to save large firms from failing or to mitigate the consequences of their failure. We need a better system of rules to deal with this moral hazard.
But the resolution authority designed by the Dodd bill might actually create more moral hazard than it would eliminate, because it would give the FDIC too much flexibility in how it resolves a failed firm. The bill’s authors appear to have cut-and-pasted the resolution language that authorizes the FDIC to wind down banks, in which one class of creditors — the depositors — are entitled to a bailout. The sophisticated creditors of non-banks, however, neither need nor deserve a bailout. The Dodd bill would not require the FDIC to impose losses on these creditors; it only expresses a “strong presumption” that such losses would be imposed.
As structured, this authority would allow the government to bail out non-bank creditors, and worse, to play favorites among them, just as we saw when the Obama administration gift-wrapped large stakes in the automakers for its union allies at the expense of secured creditors. Secured creditors would face another danger: In cases where a failed firm had both bank and non-bank businesses (like Citigroup), the FDIC could use non-bank assets to cover depositors on the bank side in order to minimize losses to its Deposit Insurance Fund, which the current crisis has depleted. The value of being a secured creditor, as opposed to an unsecured creditor, would be greatly diminished.
The good news is that it shouldn’t be too hard to fix these problems. The language needs to be scrubbed so that the FDIC has zero authority to provide creditors with better treatment than bankruptcy affords them. The resolution fund should be used only to pay obligations that are incurred after insolvency. In some cases, that money may be used to fund advance claims from creditors — claims that must be repaid if a creditor has been advanced more than it is entitled to under the law. The bank and non-bank sides of the FDIC should be walled off from each other to prevent conflicts of interest. And, if the FDIC has to borrow from the Treasury to finance any part of a resolution, taxpayers should be first in line to get paid back.
(2) Backdoor bailouts: The debate over resolution authority is merely academic, however, if the Dodd bill retains language that would give the FDIC clear authority to engage in loan guarantees during a crisis — authority it does not currently have, but which federal policymakers have been exercising anyway. You might recall that the government guaranteed more than $300 billion of Citigroup’s liabilities above and beyond money the company received under the Troubled Asset Relief Program (TARP). (Such sums dwarf the $50 billion that would be set aside for liquidation.) Under the Dodd bill, the Fed would retain the power to make loans accepting the shadiest of assets (such as subprime-mortgage-backed securities) as collateral. The Fed has used this authority over the past year to inject more than $1 trillion in new money into the economy, much of it routed through banks that stretched the definition of solvency.
The point of providing this money, then and in the future, is to prevent firms from going into resolution. It is the architecture of a permanent bailout authority, and it needs to be dismantled. This kind of flexibility, while valuable to policymakers, can quickly turn into a huge liability for taxpayers. If the power to offer such extraordinary assistance is truly necessary in the event of a liquidity crisis, regulators should have little trouble convincing Congress to give it to them, as Henry Paulson and Ben Bernanke were able to do with TARP in late 2008. But Congress should not pre-emptively hand the keys to the fisc to a group of unelected officials who, though well meaning, have precious little incentive to look out for the taxpayers’ best interest when they believe the sky to be falling.
(3) A new “consumer protection” bureaucracy: In December, as part of its own financial-reform bill, the House of Representatives passed a slightly modified version of Rep. Barney Frank’s Consumer Financial Protection Agency (CFPA) Act, which would establish a new standalone watchdog to regulate mortgages, credit cards, and much else. Such an agency would be a cumbersome bureaucracy that could impose job-killing business regulations and jeopardize financial stability. Indeed, economists David Evans and Joshua Wright concluded that the CFPA Act “would likely lead to an exponential increase in the costs and risks associated with litigation and regulation related to consumer lending products,” and would thus significantly reduce available credit. The CFPA was a big reason that not a single Republican supported the House financial-overhaul plan.
The Dodd bill would not create a formally independent consumer agency, but rather a new Consumer Financial Protection Bureau inside the Fed. Democrats say this placement is a major concession. Republicans should not be fooled. The proposed bureau would essentially operate as an independent body. It would be empowered to write and enforce new consumer rules (albeit rules that other regulators could appeal). Dodd has essentially taken Frank’s CFPA and added a fig leaf: Unlike an official standalone agency, which would have to finance itself, the bureau would be funded by the Fed. That funding may actually make Dodd’s bill worse than Frank’s, in that it insulates the bureau from oversight. Further, the bureau would have broad authority to expand the regulatory state and curtail consumer options. A GOP Senate staffer jokes that if the Dodd bill became law, the Banking Committee might as well close up shop, since the CFPB would effectively be taking its place.
For Republicans, the politics of the CFPB may seem tricky: Democrats have been gleefully painting them as opponents of “consumer protection,” and the public is understandably hostile toward credit-card companies. But the GOP should remind Americans of two underlying truths: (1) The main causes of the pre-2007 housing bubble did not include a lack of muscular consumer-protection rules. (2) To the extent that existing consumer safeguards need strengthening, the task can be accomplished without launching a massive new bureaucracy that would negatively affect credit access and economic growth.
(4) “Proxy access” for Big Labor: The unions probably won’t get their way on “card check,” but the Dodd bill offers them a nice consolation prize. Under the guise of bolstering shareholder rights, the legislation would greatly expand Big Labor’s influence over American corporations. The vehicle would be “proxy access” — allowing stockholders to have their preferred candidates in corporate-director elections be included on a company’s official proxy card. While this has been sold as a means of promoting “shareholder democracy,” its chief beneficiaries would be large and politically powerful shareholders, such as union pension funds. Proxy access has been a liberal rallying cry for many years. Its inclusion in the Dodd bill underscores the degree to which that bill represents a Democratic wish list.
We don’t have room here to tackle the dubious argument that corporations should operate like “democracies.” Suffice it to say that Dodd’s corporate-governance provisions are not designed to help mom-and-pop shareholders, but rather to increase the power of unions and other left-leaning interest groups. It would be an understatement to say that Big Labor’s agenda will often conflict with the goal of maximizing shareholder value. Shareholders are best served by sound corporate management, which the unions would seek to undermine.
The Dodd bill has other deficiencies, but we consider these four to be the most prominent and unacceptable. Until they are addressed, Republicans should oppose the legislation with all their might. Journalists will warn of the political risks (as if they’re suddenly concerned about GOP electoral fortunes) but Republicans should ignore the chatter. Rather than let Democrats claim the mantle of populism, the GOP should emphasize that Dodd’s bill would keep Bailout Nation alive while hurting the very people — middle-class consumers — it claims to be protecting. The public wants smarter, more efficient regulation of Wall Street, and there is still a possibility that Congress could produce a genuinely bipartisan reform package that would end “too big to fail” and create a sensible new resolution authority. But only if Republicans stay united.