The Limits to Discretion in the Architecture of Dodd-Frank

Martin Baily was featured as a discussant at the Pew/NYU Stern Conference on Financial Reform that took place on June 27, 2011. His program notes are below.

When Dodd-Frank passed, I was pleased that important steps forward had been made in making the US financial sector safer. In particular, placing the Fed in charge of monitoring all major financial institutions, while it was not my first choice, was still an improvement over the system that existed before in which very large institutions like AIG or risky institutions such as Bear Stearns were regulated by entities that lacked the ability to recognize the potential for failure in these companies.

On balance I ended up supporting the consumer financial protection agency, albeit somewhat reluctantly. There should always be resistance to the creation of a new agency unless it is truly necessary and there were, and still are, concerns that those who run the CFPA may not fully understand the way financial markets work. Some regulations designed to protect consumers can end up limiting the access of low income consumers to borrowing or credit cards. In the end however, there was evidence that some financial institutions had followed dubious business practices designed to exploit the forgetfulness and lack of knowledge of the borrowing public. The CFPA has the potential to help consumers.

The most important concern about Dodd-Frank is that it may have limited or undermined the ability of the Fed and Treasury to act quickly and strongly to prop up the financial system and prevent collapse in the event of a new crisis in the future.

Both conservatives and liberals alike were outraged that financial institutions received support from taxpayers. On the left, the bailouts were seen as a redistribution from poor to rich. To conservatives the bailouts created a moral hazard problem that will encourage the next generation of CEOs to take even more risks, knowing that if they fail, they will be bailed out. With both left and right united against bailouts, Dodd-Frank limited the power of the Fed to act under exigent circumstances to prevent a financial meltdown.

This was the wrong lesson from the crisis, reflecting a misunderstanding by voters and politicians of the real costs and tradeoffs of quick and decisive steps to preserve the financial sector. The direct cost to taxpayers of the bailout to Wall Street banks was very small, while the costs of failure to the shareholders and senior executives of the failed institutions were enormous, whether they were bailed out or not. The problem of moral hazard does indeed exist in our economy, in fact this problem in the health care field is driving our economy into bankruptcy. Moral hazard is certainly something that financial regulators should pay attention to. But it is hard to see future financial CEOs eagerly taking on excess risks because they are looking back at Bear Stearns, AIG or Citi and thinking the same fate would be fine for their own institutions. The moral hazard problem should be viewed through a realistic lens and not as a bumper sticker.

Despite many mistakes along the way, the Fed and Treasury did the right things in supporting financial markets and financial institutions in order to prevent a total break down of the financial sector. One of the things the movie Too Big to Fail got correct was the serious and imminent danger of economic collapse faced in the fall of 2008. Could the same thing happen again? It is less likely because of the positive steps taken to improve supervision, but in one important way the current situation is worse than before. Our financial institutions are even more concentrated than they were before the crisis, having merged under pressure from the Treasury. Multiple failures among these large institutions would be even more serious for the economy than last time, and we have limited the power of the Fed and the Treasury to deal with such a crisis.

The second question with Dodd-Frank is whether or not it is creating an unwieldy structure that will inhibit the productive workings of financial markets. Recall that our financial system was highly regulated before the crisis. Citi had rooms full of people that were supposed to be poring over the books making sure that everything was alright. Insurance companies, large and small were and are highly regulated. The problem in the crisis was that no one thought through the consequences of a 30 percent decline in home prices. No one thought this was possible. (Almost no one). The problem of ineffective regulation was greater than the problem of not enough regulation.

I want to give Dodd-Frank the benefit of the doubt here. The nature of the new regulatory system is emerging with some international cooperation and it will fix some of the obvious problems of the old system. We must make sure the result is a more effective system of regulation and not just a series of process changes that are a goldmine for accountants without much increase in safety. It would be nice to see steps taken to improve the pay and training of lead regulators, on the one hand, and to see evidence that those regulators who failed to regulate effectively in the crisis have been relieved of their jobs.

The Resolution Mechanism

Dodd-Frank limited the Fed’s power to act under exigent circumstances and has set up in its place a process that is not designed to avoid the failure of large institutions but to resolve these institutions in the event that they fail. This resolution authority has been given to the FDIC. I have read the FDIC white paper on resolution and what it would have done in the case of Lehman and I did not fully understand the process.

Much of what is written about the resolution process seems designed to reassure politicians and the public that it is not a bailout. OK, if that is indeed the case, it should be viewed as a kind of better bankruptcy procedure. How much better? Any objective observer who looks at what happened to global financial markets after the Lehman bankruptcy would say that it was a disaster. Financial markets went into free fall, the Fed was forced to step in and provide huge guarantees, the stock market dropped like a stone, with the Dow falling to around 6,000 some weeks after the event. It is natural during a crisis for everyone to try and move their wealth into a safe place and avoid whatever disasters may be ahead. Collectively, this response triggers runs on financial institutions and can cause financial collapse. So a better bankruptcy would have to avoid these consequences and it is important that the FDIC provide a clearer understanding of how it will accomplish this as part of its modified bankruptcy process.

The other alternative is to view the FDIC resolution process as actually a bailout in disguise. Lehman had $50 to $70 billion of bad assets that Treasury refused to guaranty and so the viable parts of Lehman could not be sold to the Koreans or Barclays or anyone else. The FDIC says that it would have created a bridge institution and kept the viable parts of the institution afloat and available for sale. This sounds like they would have done what Treasury refused to do, namely take over the bad assets and sell the rest. Since I have argued above that bailouts may be better than meltdowns, I guess for me this version of the FDIC resolution process is preferable. But putting the FDIC in this role is surprising and creating a bailout in disguise is not what Dodd-Frank advertized that it was doing. The FDIC is the caretaker of insured deposits and not the curator of financial markets. And I do not see how the FDIC would have the resources or authority to respond quickly and effectively to a future situation where multiple large and small institutions were failing and global markets were in turmoil.

Perhaps other people understand all of this, but as a representative citizen I would like to feel more confident about the new resolution process and how it will forestall future crises of the kind that followed Lehman. Indeed it would be an instructive exercise to commission an independent research study that would rerun the crisis period with the new limits on Fed power and the FDIC resolution mechanism both assumed to be in place and ask whether or not the researchers believe the outcome would have been better or worse than the one we actually had. Stress tests for banks are clearly a good idea and stress tests for policy seem like a good idea too.

Since these comments have focused on areas of concern about Dodd-Frank, let me conclude with some praise. It was essential that steps be taken to make the system safer and to avoid the excessive risk taking that brought down the economy. As the new regulatory structure emerges there are many elements that undoubtedly will make banks safer. Higher capital requirements, better reporting, a more unified regulatory structure for large institutions and the creation of the FSOC to monitor developments are all positive steps. Unfortunately we are not protected today from a new financial crisis because sovereign debt is now vulnerable, including Treasuries. But for a while at least private sector financial institutions should not generate a new crisis like the last one.