Will Dodd-Frank prevent future bank bailouts?

MF Global’s meltdown was a disaster for its customers, but at least it proved to be “small enough to fail”: the firm went bankrupt without destabilizing the entire market, and taxpayers were never on the hook for a bailout. There’s growing concern, however, that the same won’t hold true for the biggest banks and financial firms, and that the bailouts of 2008 and 2009 could happen all over again. Even though Dodd-Frank was intended to prevent “Too Big to Fail,” some critics argue that the law doesn’t go far enough to keep firms from exploiting loopholes and becoming bigger under the presumption that the government will bail them out if need be.
(REUTERS)

Dodd-Frank does intend to make it easier for failing or distressed banks to sell off operations, raise capital and close down. It also gives the government new authority to help liquidate firms and avoid taxpayer bailouts, ensuring that firms’ shareholders and creditors bear the losses. Problem is, this “resolution authority” applies only in the United States. So, as MIT economist Simon Johnson explained during a congressional hearing on the issue this week, distressed global megabanks could still majorly threaten the U.S. financial system if they go down in a big, messy way. What’s more, there’s nothing explicitly prohibiting the government from making emergency rescues. And even when they do have the resolution authority over a bank, Johnson points out that it’s unclear whether federal officials would be quick enough and courageous enough to liquidate a firm if they see problems on the horizon, but before a bankruptcy is imminent.

To address some of these weaknesses, Johnson advocates for imposing hard limits on the asset size of financial institutions, making them “small and simple enough so they can fail — i.e., go bankrupt — without adversely affecting the rest of the financial sector.” Together with James Kwak, he’s proposed a maximum size limit of 4 percent of GDP for commercial banks and 2 percent of GDP for securities firms, using the approximate size of the biggest financial players in the mid-1990s — before the current era of speculative, volatile trading — as a guide.

Johnson would also increase capital requirements, so at least domestically, U.S. firms would be better protected. Finally, the United States would urge leading European nations to do the same to shore up their financial system and provide a more equal playing field. (Though the Eurozone crisis makes this unlikely in the near future, it also highlights the need for better-capitalized banks.)

But an inflexible, concrete cap on bank size has little political chance of passing any time soon: Congress overwhelmingly voted down a similar proposal during the Dodd-Frank debate. “Who determines when a bank becomes ‘too big’? By what measure?” asks Phillip Klein of the Washington Examiner. And some supporters of Dodd-Frank argue that “there is nothing inherently wrong with size in and of itself,” as Sheila Bair, former FDIC chair, said at Wednesday’s hearing.

Art Wilmarth*, a law professor at George Washington University, alternatively suggests forcing banks to pay a kind of insurance risk premium to finance the future costs of resolving failed banks and firms that threatened the entire financial system. He would also make banks spin off some of their riskier activities — namely their derivatives trading and dealing activities — into non-bank affiliates, in line with a proposal that was ultimately watered down during the Dodd-Frank debate. He points out that the U.K.’s Cameron government has already pledged to impose stricter separation between “utility” and “casino” banking operations, arguing that the United States and Britain could set a new precedent by their leadership.

Wilmarth argues that these measures are necessary in the United States precisely because investors in these big financial firms still believe that the government will bail them out, if need be, fueling a sort of “moral hazard” that critics say distorts the market. He cites a recent paper by Joseph Warburton and Deniz Anginer:

We find that expectations of state support are embedded in credit spreads on bonds issued by large U.S. financial institutions. ... Debt holders of major financial institutions have an expectation that the government will shield them from losses and, as a result, they do not accurately price risk. This expectation of public support constitutes a subsidy to large financial institutions, lowering their funding costs. ... Passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in July of 2010 did not eliminate investors’ expectations of government support.

To a certain extent, the underlying criticism and concern echo the anti-bailout message that’s animated popular movements on both left and right. But most Republicans argue that the solution is to do less, simply repealing big interventions like Dodd-Frank. But critics like Johnson and Warburton believe the answer is to do more, arguing that allowing financial institutions to operate without certain risk restrictions would start the meltdown-bailout cycle all over again.

*Update: The original post identified this hearing as Joseph Warburton of Syracuse University. It was Art Wilmarth of George Washington University.