3 Reasons the Dodd-Frank Act Doesn’t Solve Too Big to Fail

American Money

On June 26, the House Committee on Financial Services held a hearing entitled “Examining How the Dodd-Frank Act Could Result in More Taxpayer-Funded Bailouts.” The focus of the hearing was clear: do Titles I and II of the Dodd-Frank Wall Street Reform and Consumer Protection Act actually do what they are intended to do?

That is, do they eliminate the possibility of taxpayer-funded bailouts for major financial institutions? And do they appropriately address the explicit and implicit protection that too-big-to-fail institutions receive from the government?

Dallas Federal Reserve Bank President Richard Fisher and Federal Reserve Bank of Richmond President Jeffrey Lacker were both witnesses for the hearing. Each economist articulated that while the Dodd-Frank act, as Fisher put it, is an “earnest attempt to address much needed reform in the financial services industry… its stated promise to end too big to fail rings hollow.”

Here’s why.

1) It’s too complicated

“Running 849 pages and with more than 9,000 pages of regulations written so far to implement it,” comments Fisher, “Dodd–Frank is long on process and complexity but short on results.” According to the Financial Services Committee’s Dodd-Frank Burden Tracker, regulators have written 224 out of the 400 new rules and requirements outlined by the act. Those 224 rules consume 7,365 pages.

What’s more, the committee estimates that it will cost private-sector job creators more than 24 million hours of labor each year just to comply with just these first 224 rules. As Fisher put it: “Regulators cannot enforce rules that are not easily understood. Nor can they enforce these rules without creating armies of new supervisors.”

Fisher argues that, by definition, regulators are always one step before market participants. This latency creates an environment where complexity begets complexity, and creates opacity instead of clarity. If a mechanism to end too big to fail does come about, it will work in part by reducing complexity, not increasing it.

2) It legitimizes ‘too big too fail’

“As soon as a financial institution is designated “systemically important” as required under Title I of Dodd–Frank (and becomes known by the acronym “SIFI”),” testified Fisher, “it is viewed by the market as being the first to be saved by the first responders in a financial crisis. In other words, these “SIFIs” occupy a privileged space in the financial system.”

Occupying this privileged space means banks assume a significant amount of both explicit and implicit protection from risks from the government. As Lacker points out: “Research at the Richmond Fed has estimated that one-third of the financial sector’s liabilities are perceived to benefit from implicit protection, based on actual government actions and policy statements. Adding implicit protection to explicit protection programs such as deposit insurance, we found that 57 percent of financial sector liabilities were expected to benefit from government guarantees as of the end of 2011.”

This backstop distorts the market and perverts the incentive structure of large financial firms. Without the backstop, Lacker argues that “large financial firms themselves would want to be less leveraged and less reliant on unstable short-term funding. Institutions and markets would, accordingly, be more resilient in response to financial stress, and policymakers could credibly commit to forgo incentive-corroding rescues.”

3) Taxpayer dollars aren’t necessarily safe

“The Dodd-Frank Act does not eliminate “too big to fail.” The Act’s Orderly Resolution Authority allows the discretionary use of public funds in the winding-down of distressed institutions, and gives the FDIC the ability to rescue their creditors. The existence of this discretion to use public funds, in turn, seems likely to perpetuate the belief in an implicit guarantee,” testified Lacker.

Fisher described the Orderly Liquidation Authority (or OLA) as evoking “the deceptive doublespeak of an Orwellian nightmare. The “L,” which stands for liquidation, will in practice become a simulated restructuring, as would occur in a Chapter 11 bankruptcy.” Fisher argues that this restructuring is just a disguised form of taxpayer bailout.

In his testimony, Fisher articulates that if a major bank fails, the U.S. Treasury, through the FDIC, may be obligated to keep its operating subsidiaries liquid for up to five years. During this time the institution does not have to pay any taxes of any kind. “To us,” he commented, “this looks, sounds, and tastes like a taxpayer bailout, just hidden behind different language.”

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