With Dodd-Frank, Have We Solved “Too Big to Fail”? – Kogod Now
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Kogod Now / Fall 2013  / With Dodd-Frank, Have We Solved “Too Big to Fail”?

With Dodd-Frank, Have We Solved “Too Big to Fail”?

In recent memory, two major cataclysms have rocked our markets: the accounting scandal of 2002 and the financial-market panic of 2008. Both had significant impacts on the stock market, with equities tracked on the Dow Jones Industrial Average falling by more than 30 percent—reaching a low of 7,286 points on October 4, 2002, and hitting an even greater low of 6,547 on March 9, 2009.

The federal government responded to each with sweeping overhauls of the policies regulating the affected sectors. The first resulted in the Sarbanes-Oxley Act of 2002, while the second led to the Wall Street Reform and Consumer Protection Act of 2010, better known as the Dodd-Frank Act.

I watched and reacted to both of these storms up close, first as an economist for Senator Paul Sarbanes (D-MD), and then as Senate Banking Committee Chair Christopher Dodd’s (D-CT) chief economist and as Deputy Assistant Secretary of the Treasury under Secretary Timothy Geithner. In both instances, the sense of crisis was palpable.

In 2002, it seemed as though every week a company with a household name collapsed. The week that the Sarbanes-Oxley Act (in an early form) was first approved by the Senate Banking Committee—the first step in the traditional legislative process—the accounting debacle took down WorldCom. While the problems at Enron may have grabbed more of the headlines, WorldCom was actually a much larger bankruptcy.

Certainly, the failures of the financial crisis—Bear Stearns, Lehman, AIG, Wachovia, Fannie, Freddie, General Motors, and Chrysler—are fresher in our minds. Most were handled at some point by the government through special legislation, including the Emergency Economic Stabilization Act of 2008, which established the Troubled Asset Relief Program (TARP).

Despite their similarities, these two upheavals affected the overall economy very differently. One led to the greatest recession since the Great Depression, while the other was halted in its tracks. The economy continued to grow and, although many individuals and communities felt significant effects, the accounting crisis did not lead to a recession, let alone a global financial meltdown.

One of the main reasons for the difference is the unique role that our financial services sector plays in our economy.

The financial services sector serves as an intermediary, connecting individuals and businesses who wish to invest (savers) with those who have productive uses for those funds (borrowers). Banks obtain money from a broad range of savers, and then make loans to potential borrowers on terms that compensate the bank for the risk they assume, plus a profit. In the absence of banks and other financial services companies, individual savers and borrowers would have to find ways to connect with each other, learn to trust one another, and arrive at mutually agreeable terms for borrowing—a very expensive, inefficient, and risky process.

The role that banks and other companies fill as financial intermediaries is tremendously beneficial to any economy. Much like oil in a car, financial intermediation lubricates our economy by ensuring that money is properly circulated throughout our economic engine.

Unfortunately, this means that financial crises have the potential to cause greater damage than other types of crises. If another sector in the American economy fell into distress, the harm to our economy would be real, but likely limited to that sector. With a sufficiently diverse economy, such a crisis would not be likely to spill over into every other sector. However, because the financial system serves as a lubricant to all sectors of the economy, a catastrophe in that sector affects almost everyone.

When the financial sector enters a crisis, the typical first reaction of financial companies is to stop lending and hoard cash so that they can survive in a more uncertain environment. However, as we learned too well after 2008, when financial companies stop lending, the effects are felt on Main Street. When banks don’t lend, businesses and consumers suffer. Worse yet, suffering businesses reduce hiring and often resort to layoffs, leading to higher unemployment and a decline in consumer spending.

This can become a vicious cycle. No wonder there was bipartisan action by Congress in the Bush and Obama administrations to prevent the collapse of the financial system. Understandably, these responses have led to public backlash, which has reasonably focused on the idea that some financial companies are “too big to fail.”

One of the central goals of Dodd-Frank was to tackle this problem. The legislation’s very first sentence is, “An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practice, and for other purposes.”

However, the question of “too big to fail” contains two separate issues. The first is whether financial companies of a certain size are undesirable merely because of their size—whether they are simply “too big.” The second question is whether the failure of a specific firm would result in a broad financial crisis; in other words, whether we have a system where every financial company, regardless of size, can be allowed “to fail” without causing serious damage to the entire financial system.

In examining the efficacy of Dodd-Frank at the Bipartisan Policy Center (BPC), we considered whether implementing legislation has put us on a path to solve the “to fail” problem. The law’s main tool to accomplish this was the expansion of powers to the Federal Deposit Insurance Corporation (FDIC), authorizing it to develop a new failure resolution regime capable of handling the failure of any systemically important financial institution (SIFI).

The FDIC’s failure resolution authority before Dodd-Frank was limited. Before the crisis, the FDIC could only resolve commercial banks; the agency lacked authority over Bear Stearns, Lehman Brothers, and AIG. Dodd-Frank transformed this, giving the FDIC broad new powers to develop a new system for these non-bank SIFIs.

Yet Dodd-Frank did not prescribe exactly what regime the FDIC should implement. Thus, even after the act’s passage, doubts remained about whether the FDIC would be able to develop and implement a system that could reasonably allow any SIFI to fail without requiring a bailout or causing a financial panic.

The FDIC responded by proposing a new system known as “single point of entry.” Under this system, the top level of the failed company (the holding company) would be put into receivership, while its operating subsidiary companies would continue to operate. As long as the holding company had enough long-term debt that it could not flee in a crisis—a critical requirement which must be properly implemented—the debt would form the basis for equity in a new, hopefully failure-free, company.

BPC recommends several important modifications to the bankruptcy code that could allow it to function in a similar manner, with or without the FDIC’s involvement. We believe a workable, reformed bankruptcy system is preferable to an FDIC-led resolution.

Our research indicated that this approach could be considered a breakthrough, allowing any systemically important financial companies to be properly resolved without requiring a taxpayer-financed bailout or triggering a destructive financial meltdown. BPC’s full report, “Too Big to Fail: The Path to a Solution,” goes into greater detail about how this could work and makes more than 40 specific recommendations to financial regulators and Congress on how to improve the system.

These include requiring that the holding company’s long-term debt be at least one year in duration; that the FDIC should confirm it will not use its general discretion to discriminate among similarly situated creditors; and that the FDIC and the Federal Reserve should better align the “living will” resolution planning process (required under Dodd-Frank) to the potential use of the single point of entry regime.

History is quite clear: eventually, there will be another financial crisis. There will also be another accounting crisis. The measure of the policies enacted is not whether they prevent any future calamity from occurring; that is impossible. The real test will come when the next crisis materializes, and we all discover how vigorous these policies are in mitigating the potentially disastrous effects.

After the Great Depression, we created deposit insurance. It didn’t stop bank failures; witness the savings and loan fiasco of the 1980s or the recent financial panic. It did, however, create a framework that protected millions of American families and businesses, and made those crises far less damaging than they otherwise would have been. With any luck, we will be able to say the same thing about the “too big to fail” provision in Dodd-Frank.

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