Does Dodd-Frank Cure ‘Too Big To Fail’?


WORD ON THE STREET: The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by the president last July, was intended, in part, ‘to end 'too big to fail'’ and ‘to protect the American taxpayer by ending bailouts.’ Treasury Secretary Tim Geithner, testifying before the Congressional Oversight Panel (COP) in June 2010, shortly before the act's passage, said, ‘The reforms will end "too big to fail.'’

The act's proponents cite several provisions as particularly important components of this effort. These include, among others, creation of the Financial Stability Oversight Council (FSOC), charged with, among other things, the responsibility for developing the specific criteria and analytic framework for assessing systemic significance; granting the Federal Reserve new power to supervise institutions that the FSOC deems systemically significant; granting the Federal Deposit Insurance Corp. (FDIC) new resolution authority for financial companies deemed systemically significant; requiring the development of "living wills" designed to assist in the orderly liquidation of such companies; and granting regulatory authority to set more stringent capital, liquidity, and leverage requirements and to limit certain activities that might increase systemic risk.

Whether these provisions, which rely heavily on the discretion and actions of the financial regulators, will ultimately be successful remains to be seen. First, many commentators – from government officials to finance academics to legislators – have expressed concern that the act does not solve the problem. For example, Kansas City Federal Reserve Bank President Thomas Hoenig has repeatedly expressed "doubt that our too-big-to-fail problem has been solved," noting in December 2010 that "after this round of bailouts, the five largest financial institutions are 20 percent larger than they were before the crisis. They control $8.6 trillion in financial assets – the equivalent of nearly 60 percent of gross domestic product. Like it or not, these firms remain too big to fail."

Massachusetts Institute of Technology professor Simon Johnson argued in September 2010 that "there is nothing [in the act] that ensures our biggest banks will be safe enough or small enough or simple enough so that, in the future, they cannot demand a bailout – the bailout potential exists as long as the government reasonably fears global financial panic if such banks are allowed to default on their debts."

Sens. Sherrod Brown and Ted Kaufman, among others, have noted that "too big to fail" isn't just the U.S.' problem, but the world's, and have argued that by itself the Dodd-Frank Act cannot provide the global regulatory framework required to resolve incredibly complex mega-banks operating in scores of countries. Sen. Kaufman and others have also questioned the wisdom of delegating so much responsibility to the very same regulators who performed so poorly in identifying the most recent crisis before it struck. Others, including Rep.Spencer Bachus and Speaker of the House John Boehner, have expressed concern that the Dodd-Frank Act's provisions, particularly those relating to designation and resolution, will "institutionalize" government bailouts.

Second, the new authorities in the Dodd-Frank Act are a work in progress – a tremendous amount of research and rulemaking by the FSOC, FDIC and a host of other regulators remains to be done. Their tasks will not be easy. Secretary Geithner told SIGTARP in December 2010, for example, that identifying institutions as systemically significant – one of the act's premier mandates – "depends too much on the state of the world at the time," and that he believes "you won't be able to make a judgment about what's systemic and what's not until you know the nature of the shock."

If the Secretary is correct, and regulators have difficulty properly identifying non-banks as systemically significant and, therefore, subject to the act's restrictions, then the act's effectiveness will undoubtedly be undermined. Even in the realm of the possible, the path regulators choose to take could make all the difference. FDIC Chairman Sheila Bair, for example, has argued that the FSOC should use the Dodd-Frank Act's "living will" provisions as a tool to force companies to simplify their operations and shrink their size, if necessary, to ensure that orderly liquidation is possible:

‘Under Dodd-Frank, the FDIC and the Federal Reserve wield considerable authority to shape the content of these [living will] plans. If the plans are not found to be credible, the FDIC and the Fed can even compel the divestiture of activities that would unduly interfere with the orderly liquidation of these companies. The success or failure of the new regulatory regime will hinge, in large part, on how credible those resolution plans are as guides to resolving those companies. And let us be clear: We will require these institutions to make substantial changes to their structure and activities if necessary to ensure orderly resolution. If we fail to follow through, and don't ensure that these institutions can be unwound in an orderly fashion during a crisis, we will have fallen short of our goal of ending Too Big to Fail.’ (Emphasis added.)

If either Chairman Bair's position prevails, and the Dodd-Frank Act is used to simplify and shrink large institutions as necessary, or if some other effective regime is adopted along with similar provisions being implemented internationally, then perhaps in the long run, the act will have a chance to end "too big to fail." In short, the proof will be in the pudding, and the pudding is still being cooked.

Finally, even if all the required regulations are properly calibrated and fully implemented, the ultimate success of the Dodd-Frank Act depends to a certain degree on market perception. As long as the relevant actors (executives, ratings agencies, creditors and counterparties) believe there will be a bailout, the problems of "too big to fail" will almost certainly persist.

Federal Reserve Chairman Ben Bernanke, in a speech to community bankers in March 2010, summed up the problem this way:

‘The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too-big-to-fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.’ (Emphasis added.)

In other words, unless and until institutions currently viewed as "too big to fail" are either broken up so that they are no longer perceived to be a threat to the financial system, or a structure is put in place that gives adequate assurance to the market that they will be left to suffer the full consequences of their own recklessness, the prospect of more bailouts will continue to fuel more bad behavior with potentially disastrous results. Thus far, the Dodd-Frank Act appears not to have solved the perception problem. The largest institutions continue to enjoy access to cheaper credit based on the existence of the implicit government guarantee against failure.

Indeed, [last month], one of the world's most influential credit rating agencies, Standard & Poor's (S&P), announced its intention to make permanent the prospect of government support as a factor in determining a bank's credit rating – a radical change from pre-TARP practice. According to S&P, "We believe that banking crises will happen again. We expect this pattern of banking-sector boom and bust and government support to repeat itself in some fashion, regardless of governments' recent and emerging policy response." (Emphasis added.)

S&P intends to "recognize government support throughout the cycle and not just during a crisis," and has described the U.S. government's likelihood of support for a systemically important bank as "moderately high." In short, S&P is telling the market that it does not believe that the Dodd-Frank Act has yet ended the problems of "too big to fail," and given the discounts that such institutions continue to receive, the market seems to be listening.

Secretary Geithner, in a December 2010 interview with SIGTARP, likewise acknowledged that despite the "better tools" provided by the Dodd-Frank Act, "[i]n the future we may have to do exceptional things again" if we face a crisis as large as the last one. To the extent that those "exceptional things" include taxpayer-supported bailouts, his acknowledgement serves as an important reminder that TARP's price tag goes far beyond dollars and cents, and that the ultimate cost of TARP will remain unknown until the next financial crisis occurs.

Neil Barofsky is the special inspector general for the Troubled Asset Relief Program. This article was adapted from prepared testimony that Barofsky delivered late last month to the House Committee on Oversight and Government Reform. His complete testimony can be accessed here.

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