Lawmakers on the verge of courting disaster with the Choice Act

Prohibition taught us that laws that ignore reality invite lawlessness. Prohibition not only failed to stop drinking, it corrupted law enforcement officials, begat violence, and ushered in a disregard for the law. The reform that was meant to promote law and order instead undermined both.

Motivated by similarly good intentions and similarly unrealistic assumptions about the capacity of the law to change behavior, lawmakers are again on the verge of courting disaster. The claim today: By making it impossible for regulators to bail out banks, we can prevent the risk taking that causes financial crises and the unfairness of using taxpayer dollars to protect Wall Street at the expense of Main Street.

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Lawmakers have already taken meaningful steps to limit the toolset available to regulators during a crisis. The Dodd–Frank Act significantly scaled back on the authority of the Federal Reserve, the Treasury Department, and the FDIC to provide the types of guarantees and emergency liquidity that they used to contain the 2008 financial crisis. The Financial Choice Act would go even further. 

The Choice Act would impose new, potentially insurmountable burdens on the capacity of the Federal Reserve to provide emergency liquidity to non-bank financial institutions. The Act would also eliminate the authority of the Treasury secretary to force a large financial institution into an orderly resolution procedure overseen by the FDIC if he determines that doing so is the only way to preserve financial stability.   

There are three ways that the aggregate scaling back of emergency powers could play out. Option one is that it will work just like advocates envision. The lack of a government safety net will reduce risk taking and the private sector will be able to clean up its own mess should problems arise. These assumptions may well hold, some of the time. If a financial institution fails because it took different and greater risks than other institutions, for example, the revised bankruptcy provisions may enable that institution to be resolved without threatening the rest of the financial system.

In most financial crises, however, these conditions do not hold.  Crises arise when numerous banks find themselves exposed to the same to risks or when bank-like activity migrates outside the regulated banking sector.  Both of these challenges contributed to the depth of the 2008 crisis and history suggests that they will inevitably arise again. This is where options two and three come in.

Option two is that regulators abide by the restraints imposed on them and sit on their hands while the financial system implodes around them. If the Great Depression is any guide, regulators who believe in forcing banks to stew in their own juices may favor this path. We know how that turned out: A record number of bank failures led to a dramatic contraction in credit and a recession so great that it scarred all who lived through it. There is little reason to believe the next time would be any less devastating. 
Option three is that regulators would refuse to stand idly by as disaster unfolds. Stripped of tools designed for crisis fighting, they would be forced resort to tools meant for very different aims. The Federal Reserve might engage in aggressive easing of monetary policy even when conditions do not otherwise merit such a response.  Bank regulators may forebear rather than closing troubled institutions. Bank regulators might also provide backroom deals to get healthy banks to acquire unhealthy counterparts. Each of these actions could help contain a spreading crisis, but each would also undermine the rule of law and give rise to new and unnecessary risks. Lawlessness is never pretty, but the alternative is sometimes worse.

Stripping financial regulators of the tools required to fight financial crises is a gamble that the next time will be different. Maybe the reforms will convince bankers to cease taking big risks. Maybe short-term depositors will never again panic. Maybe the next financial crisis won’t cost jobs or inflict other harm on the real economy. Each is theoretically possible, just like it’s possible that a law prohibiting drinking would bring about a new era of sober enlightenment. If, however, the reforms turn out to be helpful but imperfect in achieving the desired aims, this is a very costly gamble for lawmakers to take.
 
Kathryn Judge is a Professor of Law at Columbia Law School. She serves on the Financial Research Advisory Council of the Office of Financial Research, and as an editor of the Journal of Financial Regulation. 

The views expressed by this author are their own and are not the views of The Hill.