When the next financial panic happens — and it will, despite promises to the contrary — the government will be faced with the age-old quandary: should it take politically unpopular steps to intervene and try to stem the panic? Dodd-Frank changed the parameters of this question, creating both new authorities for bank regulators to act on their own, while also restricting using prior tools to require Congressional approval. There is renewed debate over whether the constriction of regulatory authority outweighs the progress made in Dodd-Frank, which it does not as overall, Dodd-Frank substantially improved regulators’ options. Where restrictions continue to occur on regulators, it is important to appreciate the political context as to why they were put in place.
In the last financial crisis, government actors, of both parties and in multiple branches, answered yes to the age-old quandary and took radically unpopular actions that prevented the Great Recession from becoming the Great Depression. The federal bank regulators, independent of Congress and comprised of people across the political spectrum, needed to — and did — act forcefully. The Federal Reserve invoked its emergency lending authority under Section 13(3) to authorize a slate of emergency lending alphabet soups, extended emergency swap-lines to central banks around the global, and most famously bailed out Bear Stearns and AIG, two financial services firms which were not under the Fed’s regulatory authority. The FDIC used its ‘systemic risk’ authority in a novel, unprecedented manner to guarantee bank liabilities across a wide array of banks. While a huge success in terms of stabilizing the banking system and making a tidy profit for the taxpayer, it was a totally unprecedented and expansive use of what been considered a far more narrow legal authority.
The central bank and the FDIC were created with a large degree of independent autonomy precisely because they have to take politically unpopular decisions such as raising interest rates or closing ailing banks. Each agency had refrained from using this authority during other episodes of financial instability, but knew when it was time to act and had the courage to do so. In part, those actions were taken because there was no comprehensive legal authority to address non-commercial bank financial firms like Bear Stearns and AIG from a failure outside of a bankruptcy code that was and is ill-suited for dealing with financial firms.
Dodd-Frank fixed that by creating a comprehensive legal framework, called orderly liquidation authority (OLA), and giving that authority to the FDIC. This change was advancement and is a core element of Dodd-Frank; efforts to repeal it are misguided and based on either faulty logic on how the problem of ‘Too Big to Fail’ is best solved, or on budgetary gimmicks that show fictional savings to taxpayers from its repeal. However, OLA can indeed be improved on. Specifically, enhancing the U.S. bankruptcy code to better deal with failures of financial firms, through the new ‘Title 14′ approach which adapts the bankruptcy code to work far better for financial firms should be adopted. Congress is making progress in this direction already. When added to OLA, Title 14 will make our system even more resilient.
Eight years ago, with a presidential election only days away, political leaders across the spectrum displayed astonishing courage in supporting unpopular but necessary action. President George W. Bush proposed what became known as the Troubled Asset Relief Program (TARP) whiles both candidates for president at the time, Senators Barack Obama and John McCain, supported and voted for TARP. Legislative action to stem the crisis was bipartisan. Despite the House of Representatives’ originally voting TARP down, the Senate came back only weeks later to pass TARP with a strong bipartisan 74-21 vote, with almost equal support across the aisle. The House followed suit, and amazingly, 32 days before a presidential election, America’s largest financial bailout law was enacted. Congress taking politically unpopular steps a month before a national election to stem a national crisis is an example of legislative courage. Some members of Congress probably lost their elections as a result of this vote, but should take solace in knowing that it is better to lose an election for doing what one believes to be right than win one by doing something that one believes to be wrong or politically expedient.
While TARP stemmed the crisis, much damage from the financial panic, and the underlying bad lending and unsustainable growth, was already done. The worst recession since the Great Depression hit and political anger against those who had taken action predictably rose. And as the financial services and banking industries regained strength, the economy remained weak. The feeling in America that the banks got bailed out and the public suffered the losses grew entrenched, and with good reason. Many bankers did get rich and remained rich through the bailout era – as was the case with some in the real estate market, although that industry has escaped much of the public backlash that banking caught.
Against this backdrop, and the reality that independent financial regulators had used their authority in unprecedented and politically unpopular ways, a restriction was likely to happen. Sure enough, the Dodd-Frank Act curtailed the Fed’s ability to use its emergency lending authority to the aid of a single firm as it did with Bear Stearns and AIG. Further, the FDIC was required to seek Congressional approval to use its systemic risk exception.
These legal changes will make it harder for bank regulators to take similar actions in the face of the next crisis. However, OLA and enhanced failure resolution authority remove some of the need for these other tools to be used. Further, other parts of Dodd-Frank reduce the likelihood of a future crisis and also lower its likely severity. In totality, Dodd-Frank is a substantial improvement on the status quo pre-crisis. Picking on just one aspect of Dodd-Frank to make broader conclusions misses the mark, which is to look at the cumulative impact of the legislation.
But the status-quo pre-crisis is the wrong baseline to measure against. After the Fed, FDIC, Treasury, and Congress ‘broke the glass’ and used various emergency authorities, the political equilibrium changed. Going forward, a Congressional response was inevitable. After all, Congress’s job is to write the laws. When laws are interpreted in ways that Congress did not intend or in ways that are antithetical to the basic propositions of American capitalism, Congress will rewrite the laws.
The key question is whether Congress substantially restricted the independence of the central bank and FDIC. On that score, Congress did not. Dodd-Frank wisely resisted the siren’s song to ‘Audit the Fed’ — a proposal that gained support of the majority in both the Senate and House this Congress that would foolishly reduce the Fed’s independence on monetary policy. In fact, there are those who question whether the restrictions on the Fed’s emergency lending programs would actually work to restrict individual bailouts or whether a creative legal regime could get around that.
When the next crisis occurs, policy makers will again face the same age-old question: should they take politically unpopular steps to mitigate an even greater problem? The next time, it may come down to whether the FDIC will use its new tool of OLA at the right moment. It may come back to Congress needing to have the courage to vote to authorize existing authority or create new authority. And it may come down to the Fed being able to use its restricted emergency lending authority in the right manner at the right moment. Hopefully by then, the law will have been improved by new bankruptcy authority. But even if not, we will be in a better place than we were in 2007.