What is Dodd's Too Big To Fail Solution?

While I tend to agree with Ezra Klein’s overall argument about the need to move on financial regulation now, he misses some key points about how Chris Dodd’s bill deals with the Too Big To Fail problem.

Ezra postulates that there are two ways to deal with TBTF: One is breaking up the banks, which this bill does not do, or rather, it relies on regulatory discretion to do it. The second is instituting higher capital requirements, which Ezra also says this bill does not do. Again, sort of right: Congress typically avoids setting specific capital requirements because they need to be negotiated internationally to be meaningful (an ongoing process). That said, the lack of a clear floor for these requirements is disappointing. (It's worth noting here that changes in derivatives rules will have the effect of raising capital requirements by making it harder for banks to hide risk.) But all along, the capital requirements situation has rested in the regulatory offices; they already have the ability to change capital requirements at will, which is why Obama’s upcoming round of regulator appointments is so critical.

However, Ezra forgets the third part of the solution to the TBTF problem. He’s overly focused on the “too big” and not enough on the “fail.” Resolution authority is key. The reason that TBTF works is because bankers count on bailouts from the government. The industry knows the choice for regulators has basically been between bailouts or a messy bankruptcy. What Dodd’s legislation does, however, is restrict the ability of regulators to bailout insolvent banks; for instance, the Fed can no longer make loans to specific firms. But regulators’ ability to liquidate insolvent companies has been enhanced and given greater incentive thanks to a $50 billion fund to ease the costs of liquidation. This mechanism adds great credibility to the government’s attempts to remove the implicit bailout guarantee and reassert market discipline, and makes it harder for regulators to funnel money into the banks during an emergency.

I’d add that all of the Too Big To Fail problems shouldn’t be reduced to discussions of “bubbles,” since financial crises are not all based on asset bubbles and the problem of systemic risk is not limited to that situation, either. When regulators were making decisions about how to deal with the crisis of 2008, the problem was less their blindness about the sub-prime mortgage bubble than their inability to envision a different kind of financial system and the structural obstacles to aggressive action.

— Tim Fernholz

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