My big question over the past few months has been does Dodd-Frank do anything? It turns out it does. It outlaws government bailouts of systemically important financial institutions, which it now officially defined as anything that strikes the fancy of our cowboys in Washington. Sec. 214 of the Act reads “No taxpayer funds shall be used to prevent the liquidation of any financial company under this title.” Bailouts cost the country a lot, though the government has been able to recoup some of the loses through the repayment of loans and the sale of bank assets. The Troubled Asset Relief Program allotted $700 billion dollars to bailout these institutions, the Federal Reserve released a report on Wednesday detailing how they actually spent $3.3 trillion. In theory, this is good news to taxpayers, who will not asked to carry the burden to bailout . But in practice, the law could prevent the government from taking necessary action if and when these institution’s fail.
In an interview, Professor Roy Smith, Kenneth Langone Professor of Entrepreneurship and Finance and Professor of International Business at New York University argued just that. The truth of the matter is banks do fail. The recent failure Lehman Brothers Holdings Inc. and the government rescue of American Insurance Group and others caught widespread publicity as it coincided with the worst financial crisis since the Great Depression but this is not the only time in history when systemically important banks have been bailed out. In a yet to be published article, Smith points the example of Continental Illinois Bank in 1984, which the Fed and FDIC bailed out and was subsequently acquired by Bank of America. There have been others but never has it been as widespread as the chaos of 2008.
Smith said he is unsure why the government allowed Lehman Brothers to fail while simultaneously bailing other institutions considered too-big-to-fail. But he said the failure of Lehman Brothers caused a “contagion that spread.” The bank’s failure set off a panic in the market, resulting in a wide spread run on the banking system, as it was unclear who the Fed would determine too systemically important to fail. In the aftermath that followed, the stock market plummeted and the economy plunged into the worst financial crisis since the Great Depression. At that cost, Smith said no price would have been to high to save the bank. He said he is not sure why the Fed didn’t, but said “Sometimes it’s just the fog of war.”
What does a no-bailouts policy mean for the banking system? After charging the Fed with the task of identifying systemically important institutions and banning the use of the bailout, the bill sort of stops there. There are no shortage of critics who argue one of the bill’s major flaws is that is fails to break up such institutions. In her blog on The Huffington Post (here), Barbara Roper, Director of investor protection for the Consumer Federation of America, argues “The only way to credibly pledge to prevent bailouts then is to eliminate the conditions that make them inevitable.” She argues the government could do that by breaking up such institutions and working to disentangle the web of connections that cause failing institutions to bring others down. I am not sure how we would go about the second suggestion but the first is commonly proposed.
By outlawing the use of taxpayer-funded bailouts, Smith said banks and financial institutions may opt to voluntarily take on less risk and streamline their operations so they are less likely to fail. This is the point of outlawing bailouts in the first place. But the problem is what happens when companies fail as they inevitably will? Are they going to voluntarily shed enough assets and minimize risk in a way that will prevent their collapse? The government will likely to use a bailout but it would do so at great political cost. Not that this ultimately matters but the fear is it could cause them to drag their feet, while the market experiences a period of turbulence. If they ultimately refuse, the economic consequences would be difficult to imagine. It’s a dangerous game of chicken that could lead to the taxpayer/consumer getting burned again.
The act does allow for some Fed action, reading as follows “All funds expended in the liquidation of a financial company under this title shall be recovered from the disposition of assets of such financial company, or shall be the responsibility of the financial sector, through assessments.” So really what this says is the consumer will pay for the bailouts through higher prices. It seems even Congress knows bailouts are inevitable if we continue on the same path. In his paper, “The Dilemma of Bailouts,” Smith even argues that once the Fed identifies a failing institution, provided it could do that before the market, it will spark a run on the company, as consumers learn about the illegality of bailouts.
So we are stuck at a crossroads where the choice is an invasion of the free market now or down the road. Do we break up the oligopolistic powers of large banks? Or risk another bailout?
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