The Problem of Committing Against Bailouts

Aug 22, 2012Mike Konczal

Economist Robert Stein had a recent post at the American Enterprise Institute about ending Too Big To Fail (h/t James Pethokoukis). His major advice, which frames the rest of his argument, is that "Ideally, the federal government would end Too Big To Fail (TBTF) by credibly pre-committing not to bailout large financial firms when they run into trouble."

There's some other problems with the piece [1], but I want to run with this statement. The implication is that the Dodd-Frank financial reform act doesn't do such things. Let's take a second and document what Dodd-Frank does in terms of pre-committing to avoid bailing out a large financial firm, and where the problems with such a process could really occur.

Federal Reserve: Dodd-Frank strips out previous language from the Federal Reserve Act that was used to execute the (unpopular) emergency lending facilities (Sec. 1101). The Federal Reserve can no longer use its 13(3) powers to, in "unusual" circumstances, provide support for an "individual, partnership, or corporation." That language has been removed, and replaced with "program or facility with broad-based eligibility.” Dodd-Frank explicitly writes into the Federal Reserve Act that "any emergency lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company." Going further it writes "The Board shall establish procedures to prohibit borrowing from programs and facilities by borrowers that are insolvent."

Provided we want the Federal Reserve to act as a lender-of-last-resort, this is a proper way to do it. At one point, even Richard Shelby seemed to think these reforms were the right approach.

Activating Resolution Authority: Now let's look at what is required to activate an orderly-liquidation action, or what is often called resolution authority. This is the FDIC taking over a failing financial institution and winding it down. If you've seen movies where two people need to turn their key to activate a nuclear weapon, then you'll understand that there's a three-key mechanism for resolution authority (Sec. 203).

The Treasury Secretary, after consulting with the President, needs to determine whether resolution is an appropriate path for a firm, one where "the failure of the financial company and its resolution under otherwise applicable Federal or State law would have serious adverse effects on financial stability in the United States." The Treasury Secretary then needs the recommendation of 2/3rds of the Board of Governors, as well as 2/3rds of FDIC (with the SEC replacing the FDIC for brokers and dealers, and the Federal Insurance Office for insurance companies), to approve going forward with resolution. So you have three institutions who have to turn their keys for resolution to go, institutions including both independent regulators and people with politicial accountability.

What should guide the recommendation for the Board of Govenors and the FDIC? Their written recommendation requires "an evaluation of the likelihood of a private sector alternative to prevent the default of the financial company" as well as "an evaluation of why a case under the Bankruptcy Code is not appropriate for the financial company." The default setting in the law is that the private sector alternative is always better to government action, and that the Bankruptcy Code is always better than resolution. This is consistent with the logic of those who want the government to pre-commit to as little action as possible.

Executing Resolution Authority: If the FDIC starts to resolve a failing financial company using its liquidation powers, what strict, legal limitations does it have to follow? There's a section titled "Mandatory Terms and Conditions for all Orderly Liquidation Actions" (Sec. 206) that can give us a start. If there's a liquidation, the FDIC has to wipe out shareholders if necessary ("ensure that the shareholders of a covered financial company do not receive payment until after all other claims and the Fund are fully paid") and hit creditors ("ensure that unsecured creditors bear losses in accordance with the priority of claim provisions").  The government isn't allowed to redo TARP or AIG and buy equity in the firm to keep it alive ("not take an equity interest in or become a shareholder of any covered financial company or any covered subsidiary"). The FDIC can't act for "the purpose of preserving the covered financial company."

They also have to fire management ("ensure that management responsible for the failed condition of the covered financial company is removed") and fire board members ("ensure that the members of the board of directors...are removed") by law. There's explicit legal language to allows FDIC to claw back compensation (Sec. 210, "may recover from any current or former senior executive or director substantially responsible for the failed condition of the covered financial company any compensation received during the 2-year period preceding"). It's difficult to imagine a firm really excited about going through such a procedure.

The Problem: Dodd-Frank goes out of its way to pre-commit against further bailouts. The problem with pre-committing against bailouts isn't Dodd-Frank; it's that the financial sector broadly will be too unstable and that Dodd-Frank won't have sufficient reforms in place to keep that in check. Remember the bailouts of 2008 were the results of GOP-appointed Hank Paulson, GOP-appointed Sheila Bair and GOP-appointed Ben Bernanke, all with the support of a Bush White House-sponsored EESA, going to Congress and asking that an emergency bill be passed to allow for TARP. Dodd-Frank cannot prevent that from happening again no matter what its precommittments are. No law can prevent Congress from acting in such a way. The best that can be done is set up the basic legal structures of the financial industry to make it so it isn't prone to collapse and abuses, and when there is failure to make sure losses are allocated in a fair way.

[1] Stein also proposes that "One way to signal this intent would be phasing out deposit insurance, a cornerstone of the government’s involvement in 'safeguarding' the financial system." Mark Calabria at Cato has called for capping deposit insurance access from its current 10 percent to 5 percent as anti-TBTF policy; Tim Carney and Matt Yglesias like this idea as well.

Let's graph out the size of major financial institutions in both their deposit and non-deposit dimensions, using a chart I use to help explain the SAFE Banking Act that would Break Up the Banks:

If we had to place Lehman Brothers or Bear Stearns, the shadow banks that caused the market panic, the shadow banks that need to be folded under traditional banking regulations, on this graph, it would clock in more like Morgan Stanley than Wells Fargo. You could proceed with such a 5% cap on deposit liabilities - though Treasury would tell you that it just forces banks to go into the more prone-to-panic and poorly regulated non-deposit/repo market for funding, as you can see from Bank of America above - but it would regulate Wells Fargo more than it would regulate firms like Citigroup, Goldman Sachs or Morgan Stanley, or the firms where the focus should be.

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