By Paul H. Kupiec - 07/30/14 07:23 PM EDT
The Dodd-Frank Act was supposed to end investors’ perception that the largest financial firms are “too big to fail” (TBTF) and remove the risk that a large institutional failure could create financial instability unless the government protected investors from loss. Four years on, Dodd-Frank has imposed huge regulatory burdens that are sapping economic growth, but it has not ended TBTF or the possibility of taxpayer bailouts.
When investors believe an institution is TBTF, they lend it money at reduced interest rates. Investors believe that the government will keep a TBTF institution from failing, including by, if necessary, injecting taxpayer money to help the institution repay its loans.
But how can Dodd-Frank reinforce investors’ belief in TBTF when it was supposed to end it?
Under Dodd-Frank, the largest institutions are subject to enhanced prudential supervision and regulations by the Federal Reserve Board. They now must meet stricter capital and leverage requirements, file detailed annual orderly resolution plans and pass the Fed’s annual macroeconomic stress test examination.
Enhanced supervision is intended to control risks by limiting large institutions’ operations and investment opportunities, but it also has unintended consequences. Supervision and regulation are now so intrusive that it is not a stretch to say that the largest institutions are being run by the Fed. In their public statements, senior Federal Reserve officials now routinely downplay the risk that easy money is causing a financial bubble, by arguing that the Fed closely monitors the largest institutions and uses its Dodd-Frank powers to impose operational changes to reduce the risk of financial instability.
With the Fed running TBTF institutions, why wouldn’t a rational investor think that his or her investment is protected?
Supporters of Dodd-Frank, including former Rep. Barney Frank (D-Mass.) himself, have argued that the law makes taxpayer bailouts illegal and that investors in TBTF firms are wrong to think they would be protected by the government. But many investors appear to disagree with Frank and for good reasons.
Dodd-Frank Orderly Resolution plans are supposed to make it possible for a large financial institution to go through a judicial bankruptcy process without government assistance and without causing financial instability. The problem is, these plans won’t work.
The recent House Financial Services Committee Republican report discusses the flaws in these plans. Orderly Resolution plans have been compared to pre-packaged bankruptcies, or blueprints for speedy reorganizations using bankruptcy that will keep financial institutions open and operating and thereby remove the risk of financial instability. On close examination, this analogy breaks down because these plans lack creditor participation. The key to a successful prepackaged bankruptcy is creditor acceptance of a debt restructuring plan before entering bankruptcy. But creditors do not approve Orderly Resolution plans. The plans are kept secret from creditors, and the institutions filing the plans are not even obligated to follow them in bankruptcy.
When Orderly Resolution plans don’t work, and the regulators decide that a bankruptcy would create “systemic risk,” Dodd-Frank’s Title II is supposed to provide a failsafe backup mechanism for resolving large failing financial institutions. Title II was sold as a resolution process in which the Federal Deposit Insurance Corp. (FDIC) manages a large financial institution failure without causing financial instability and without using taxpayer bailouts. But once again, sharp-eyed investors can see through the marketing hype.
Using the FDIC’s Single Point of Entry strategy, a Title II resolution maintains financial tranquility by insuring all of the liabilities of the failing institutions’ subsidiaries. In most cases, one of the subsidiaries will be a large failing bank. When this happens, Title II extends a full government bailout to all of the bank’s uninsured liabilities. In other words, Title II will fully protect investors who would have taken losses in an FDIC bank resolution and holding company bankruptcy. So Title II reduces the “systemic risk” caused by the institution’s failure by extending a larger government guarantee and bailing out investors who would have lost money if the firm had gone into bankruptcy.
If the FDIC does not recover enough in a Title II resolution to fully offset the government’s bailout cost, Dodd-Frank requires that all remaining large financial institutions repay the government’s expenses, making taxpayer bailouts technically illegal. But are taxpayers really off the hook for paying for the bailout? Hardly.
In the last crisis, the Federal Reserve began paying interest on bank excess reserves. Excess reserve balances subsequently skyrocketed to more than $2.5 trillion, and the Fed has channeled billions of taxpayer dollars into banks in the form of interest payments on excess reserves. There is nothing in Dodd-Frank that prohibits the government from using this channel to provide the largest institutions with the funds they will need to pay Title II bailout assessments after the next financial crisis.
Kupiec is a resident scholar at the American Enterprise Institute. He has also been a director of the Center for Financial Research at the Federal Deposit Insurance Corp. and chairman of the Research Task Force of the Basel Committee on Banking Supervision.