Does Dodd-Frank really end ‘too big to fail’?

March 2, 2013

With Romney's defeat, the Dodd-Frank financial regulations are here to stay. But that doesn't mean the debate over them is finished. Bloomberg View recently estimated that the law provides the equivalent of an $83 billion subsidy to the biggest banks — a figure questioned by Wonkblog here  and skeptical lawmakers quickly used the number as a cudgel against the reform.


Got room for one more coin? (Gerald Herbert/Associated Press)

"The bottom line is Dodd-Frank didn't end too big to fail," Rep. Jeb Hensarling, chairman of the House Committee on FInancial Services, told Fox Business News. "Dodd-Frank institutionalized and codified too big to fail."

To give a sense of where the current debates on Dodd-Frank and Too Big to Fail stand, I’m going to examine three of the most common questions debated among experts.

1. What does it mean to end bailouts and Too Big To Fail?

Bailouts in periods of financial crisis appear to be unfair because they play by special rules that only go into effect when a bank is already about to fail and are decided on a case-by-case situation (for Latin fans, bailouts are ex post and ad hoc). Bailouts prevent those who stand to gain the most in good times from also losing the most in bad times. Hank Paulson’s original request for bailout money without strings attached, in a three-page bill no less, remains one of the bailouts most unpopular legacies.

Yet the dangers of unaddressed financial crises are real. This kind of systemic risk is like a contagion, where failures at one business spread to everyone. One example of this is bank runs, where the failure of one bank makes everyone rush to pull their money out of other banks. A version of this, a “shadow banking run,” happened in the capital markets and on Wall Street during the latest crisis.

Dodd-Frank tries to deal with these issues by creating the rules for a crisis in advance. It requires stricter regulations on capital and activities for the largest and riskiest financial firms, to make them less likely to fail in a crisis. Dodd-Frank also grants the FDIC a special new power called resolution authority. This allows the government to run a bridge company to keep essential operations running at a failed firm that needs to be liquidated, with losses put on those who deserve them, rather than putting taxpayers at risk.

So what do critics have to say? The first objection is that all of this is unnecessary – there’s no such thing as systemic risk. Bank runs usually don’t happen, but when they do they are necessary, and they don't threaten the surrounding financial system. This laissez-faire approach doesn’t carry much weight among scholars.

The second criticism —  he one Hensarling is making  is that resolution authority is a permanent, unfair bailout. Some argue that the FDIC will use their powers to bailout creditors instead of imposing losses on them. Others worry that the FDIC’s ability to borrow money and provide bridge money is an unfair practice that puts taxpayers at risk of losses. The underlying concern is that stakeholders in the financial firm won’t care if they go through resolution authority, and as such, resolution authority makes them a safer bet and acts as a kind of permanent bailout promise to the markets.

However, the structure of Dodd-Frank’s resolution authority is explicitly designed to avoid bailouts. Numerous regulators must approve the activation of this process, and they have to argue that either the bankruptcy code or “a private sector alternative to prevent the default” aren’t available or appropriate instead.

Meanwhile, if a firm goes into resolution the FDIC has to wipe out shareholders and hit creditors in a way designed to mimic bankruptcy. It is blocked from buying equity in the firm, like in TARP or AIG, and can't act for "the purpose of preserving the covered financial company." It also has to fire management, board members, and has the option to claw back previous compensation. It’s difficult to imagine a firm wanting to go through this process. If any taxpayer money is put on the line, it has to be recouped from the financial sector as a whole; this is appropriate, because the government is acting to preserve the financial sector as a whole.

The third criticism is that this isn’t a credible threat because the largest financial firms are too risky, too complex, too international and contain too much political clout for these painful measures to be tried. This criticism is where people look to change what Dodd-Frank does, either through an expansion or limitation.

2. Does Dodd-Frank do too little, or too much?

Here is where breaking up the banks, either along business lines and or in size, comes into play. Senator Sherrod Brown (D-Ohio) and former Senator Ted Kaufmann (D-Del.) proposed an amendment designed to break up the banks during Dodd-Frank, with a cap on the amount of non-deposit liabilities at 3 percent of GDP. At the time, here are the firms it would have impacted:

This is no longer accurate, as the biggest firms are now even bigger. Brown is now teaming up with Senator David Vitter (R-La.) to propose a similar law to break up the banks, an idea that is gaining in popularity.

Another area that many feel needs additional reform is the treatment of short-term creditors and other panic-prone sectors like the money market mutual funds. Regulators, through the Financial Stability Oversight Council, are trying to lead where the SEC has not had success here.

But there are those who feel Dodd-Frank goes too far. William C. Dudley, president of the Federal Reserve Bank of New York, argues that Dodd-Frank took away too much of the ability to lend in an emergency through the Federal Reserve’s special 13(3) powers.

This is an important debate. There was a lot of time and energy that went into rewriting these emergency lending powers during Dodd-Frank. The final rule that the Senate came up with was to allow the Federal Reserve can only lend “for the purpose of providing liquidity to the financial system, and not to aid a failing financial company." Further, it can’t lend to borrowers it believes are insolvent.

Others have argued that if resolution authority works and we can impose losses on financial firms, we don’t need any additional regulations, and can start pulling back on reform like the Volcker Rule or new rules on derivatives. This is the equivalent of saying that since cars now have air bags, we don’t need to have speed limits, stop signs, or any other traffic laws. The failing of a major firm is still risky enough to have a significant market impact, and having multiple rules reinforce each other is smarter than relying on just one, risky rule.

One popular way of requiring the financial sector to be less risky is for banks to hold more capital. But what form should it take?

3. How much extra capital should banks hold, and what should it look like?

Even with the new Basel requirements, many experts are worried that banks will remain under-capitalized going forward. In their recent book, “The Bankers New Clothes,” Anat Admati and Martin Hellwig say that banks should hold more equity. A lot more equity. They argue that banks’ equity should be on the order of 20-30 percent of their total assets. The Systemic Risk Council, which includes people like former FDIC Director Shelia Bair, calls for raising equity a bit more modestly, to 8 percent.

Others think that we should instead require banks to hold special types of debt. A long-standing argument is that banks should hold debt that converts into equity contingent on whether or not they are in crisis (these are often called “coco” bonds). Many others argue that a market trigger, like a CDS, could be used to convert these debts, though this approach assumes deep, transparent, liquid markets that aren’t susceptible to manipulation.

Admati and Hellwig refer to this second approach as the “anything but equity” approach. Instruments like coco bonds could cause additional turmoil and death spirals at companies. Meanwhile, the implementation and triggering of such instruments poses additional regulatory problems that equity does not. In response, others argue that high levels of equity will be way too expensive for banks relative to these instruments.

Notice how these debates go together. Financial institutions that are more silo’ed, better regulated and have a significant amount of first-loss capital will be easier to put into resolution, and thus end Too Big To Fail. There will not be a silver bullet here – there will instead be a series of strong regulations that reinforce each other, or weak ones that undermine others.

Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality, and unemployment. He writes a weekly column for Wonkblog.

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