Upon signing the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July of 2010, President Obamadeclared, “There will be no more tax-funded bailouts -- period.” With the five year anniversary of Dodd-Frank quickly approaching, is the President’s statement correct? Have federal regulators achieved a delicate balancing act between financial safety and the efficient flow of capital necessary to grow the economy? It seems unlikely.
In late May, Richmond Federal Reserve Bank President Jeffrey Lacker delivered a speech entitled “From Country Banks to SIFIs: The 100-Year Quest for Financial Stability” at the Louisiana State University Graduate School of Banking. The speech details the history of efforts by the Federal Reserve and other regulators to maintain a robust regulatory regime focused on financial sector stability and proposes policies that will help restore market discipline.
Citing the Richmond Fed’s “Bailout Barometer”[1], President Lacker claims the federal safety net for financial services firms in 2013 was an astonishing $26 trillion, which is “more than one and a half times our country’s entire annual gross domestic product” (GDP) and represents 60 percent of the financial sector’s liabilities. By contrast, the “Bailout Barometer “in 1965 represented less than half of GDP.
What has contributed to the dramatic increase? According to President Lacker, ad hoc and arbitrary interventions into the financial sector by the federal government beginning in the 1970s that shielded “uninsured creditors of large financial firms” have led to a rise in the federal financial services safety net. Specifically, President Lacker cites Penn Central Railroad, the Bank of the Commonwealth, Franklin National Bank and, prominently, Continental Illinois in 1984 as contributing to the belief that “uninsured creditors of large institutions would be insulated from losses by the government”.
Prior to the bailouts of certain large, politically connected investment banks in 2007 and 2008, when a company became insolvent, it sought protection from secured and unsecured creditors by filing for bankruptcy. Bankruptcy is a long-standing and predictable method of resolving the liabilities of failing firms. The rules of the road have changed dramatically since 2007 and 2008 for large financial services companies.
Though not technically a bankruptcy provision, Title II of Dodd-Frank created Orderly Liquidation Authority (OLA) that allows the Federal Deposit Insurance Corporation (FDIC) to wind down certain financial services firms with funds from the Department of the Treasury. The goals of OLA are “mitigating systemic risk, which is thought to emerge when large financial firms enter the bankruptcy process, while also minimizing moral hazard, which arises when investors believe that firms are likely to be granted a government bailout to save them from bankruptcy and prevent systemic problems.”[2]
What is the result of OLA, according to President Lacker?
The authors of [Dodd-Frank] envisioned OLA as a way to put an end to taxpayer-funded bailouts. However, the FDIC’s announced plans for implementation will likely encourage many creditors to expect they will benefit from FDIC’s discretion, dampening their incentive to contain risk. If expectations of support for the creditors of financially distressed institutions are widespread, regulators will likely feel forced to provide support to these short-term creditors to avoid the turbulence of disappointing expectations. Rather than ending ‘too big to fail’, the OLA replicates the dynamic that created it (emphasis added).
What will solve the problem? President Lacker continued,
The long term solution is not more regulation. Instead, it’s to restore market discipline so that financial firms and their creditors have an incentive to avoid fragile funding arrangements. Two conditions are necessary to achieve this. First, creditors must not expect government support in the event of financial distress. Second, policymakers must actually allow financial firms to fail without government support. If we can make unassisted failures manageable, policymakers could credibly commit to forgoing rescues, thereby improving private sector incentives.
It is my hope that Members of Congress and financial services regulators use the five year anniversary of Dodd-Frank to consider ways to improve the financial sector without jeopardizing taxpayers. A copy of the speech can be found here
[1] The Bailout Barometer measures “the portion of the financial sector’s liabilities protected from loss by the federal government” and includes both explicit guarantees such as deposit insurance and implicit guarantees which “represent the support investors expect based on prior government intervention and announced policy.”
[2]Pellerin, Sabrina R., and John R. Walter. "Orderly Liquidation Authority as an Alternative to Bankruptcy." Economic Quarterly 98.1 (2012): 1-31.