Dodd-Frank: One Year Later, the Bailout Dilemma Remains

Ever since the bailout of Continental Illinois Bank in 1984, bank bailouts have been an unpopular device invoked to protect the financial system from risks posed by troubled banks deemed “too big to fail.” Many taxpayers believe that bank bailouts are an abuse of taxpayer funds, especially when bank managers are allowed to keep their jobs, stocks, severance pay, and pensions. Free-market enthusiasts, on the other hand, dislike bailouts because they thwart the corrective action that market forces would otherwise bring about. Members of Congress have heard these complaints. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in July 2010, prohibits taxpayer-funded bailouts, but it also suffers from a fundamental flaw: it leaves the financial system exposed to meltdowns.

Among other provisions, Dodd-Frank gives the Federal Reserve new authority to deal with bank and nonbank financial institutions that it believes are “systemically important,” i.e., firms previously viewed as “too big to fail,” explains New York University professor of finance Roy C. Smith in an article for the Summer 2011 issue of The Independent Review. If the Fed deems that an illiquid financial institution poses a “grave threat” to the financial system and warrants special regulatory action, the targeted firm can lobby the Financial Stability Oversight Council to block the Fed. But by then it may be too late for the targeted firm: because bailouts are off the table, the market may react to the Fed’s announcement with a run on the targeted firm, with undesirable consequences for the rest of the banking system. “The run will spread instantly throughout the banking industry, as such runs did after the Lehman episode in September 2010, and without the capacity for bailouts several firms rather than only one might end up in bankruptcy,” Smith writes.

Federal Reserve policymakers, however, are unlikely to take actions they believe would result in the bankruptcies of several of the largest financial institutions. “The only way to avoid such an outcome in a no-bailout world is never to declare a firm to be a ‘grave threat,’ which means the Dodd-Frank resolution authority almost certainly will never be used except to liquidate a bank the Fed has decided to close down,” Smith writes. Dodd-Frank is also flawed in other ways, according to Smith. For example, because it gives federal agencies new powers to scrutinize and regulate large financial institutions, riskier financial transactions would gravitate to smaller, less-regulated institutions. “The nonbanks that take over these businesses,” Smith continues, “will endeavor not to become large enough to become systematically important under Dodd-Frank.”

In other words, Dodd-Frank is designed to look as if the government has new powers to prevent financial crises, but the fine print reveals a different picture.

The Dilemma of Bailouts, by Roy C. Smith (The Independent Review, Summer 2011)

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[A version of this post appeared in the July 26, 2011, issue of The Lighthouse. To receive this weekly email newsletter of publication summaries and event announcements from the Independent Institute, enter your email address here.]

Carl Close is Research Fellow and Senior Editor for The Independent Institute and Assistant Editor of The Independent Review and editor of The Lighthouse, The Independent Institute’s weekly e-mail newsletter.
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