The Dodd-Frank law is now five years old, but the struggle over how to implement financial reform continues unabated–and there is a danger that sensible policymaking is losing out. Ben Bernanke recently wrote about the dangers of the proposed Vitter-Warren bill, which would restrict the Federal Reserve’s emergency lending authority, going beyond the restrictions already in the law. In addition, there is another very important struggle taking place: How should large banks be regulated to avoid “too big to fail”?
One answer is to make the large banks safer, and this has been done through a variety of measures, notably through capital and liquidity requirements. In accordance with Dodd-Frank, regulators have sharply increased the amount of capital that banks must hold. They also require large banks to undergo stress tests and make sure they have enough capital and liquidity to survive a very serious new financial crash. The banks must also hold a combination of equity capital and long term unsecured bonds large enough to act as a shock absorber—the so-called total loss absorbing capacity or TLAC.
Dodd-Frank did not just require that large banks be made safer; it also laid out provisions for the resolution of a large bank if it should fail. Getting the failure resolution process right is not just important for the next crisis it has an immediate impact on how the large banks are currently regulated. The Federal Reserve was designated as the primary regulator of the large banks, but the Federal Deposit Insurance Corporation (FDIC) was given the task of overseeing large-bank failures.
Unfortunately, Dodd-Frank is complex and potentially inconsistent in how it dealt with such failures. Under Title I of the act banks must draw up “living wills,” which document how they might be put into bankruptcy under the authority of a judge. At the same time, Title II of the act provides that if a large institution becomes insolvent and its failure would cause problems to the whole financial system, then the FDIC would step in and take over the institution keeping essential subsidiaries open for business, at least for a period of time, and avoiding system-wide disruption. The approaches to failure resolution under the two titles of Dodd-Frank are different and hard to reconcile.
The good news is that the FDIC showed great creativity by coming up with the “single point of entry” approach for Title II, which allows large banks to fail without a huge disruption to the system. At the same time, the law ensures there would be no loss to taxpayers and hence no bailout. (If Treasury funds are used to support a failing institution under Title II, the industry is on the hook to reimburse any taxpayers losses.) This approach has been applauded by other countries and is being adopted internationally. It was a huge innovation in financial regulation that makes the financial system much safer and takes away any benefit large banks had in the past from being too big to fail. This solution is not one the large banks love because they are required to hold a large and expensive cushion of long-term debt and equity (the TLAC).
Rather than encouraging regulators to build on the single point of entry approach, some politicians are pushing regulators to use the living will provision of Title I of Dodd-Frank to force the breakup of the large banks. In requiring the living wills, Congress presented an extremely difficult task for global banks with diverse business lines.. Bankruptcy law traditionally was not designed for failing large banks, and the courts did not have the tools they would need to avoid triggering financial disruption. The experience of the Lehman Bros bankruptcy is a warning of the dangers inherent in bankruptcy. There has been progress made in making it possible for a large bank to be resolved in a court, as Martin Gruenberg, the head of the FDIC, highlighted in a recent speech, but it will take time and much back and forth between regulators and banks to complete this process. Congress should be helping regulators to better harmonize Title I and Title II provisions of Dodd-Frank using the single point of entry approach as the organizing framework for both.
If it were really necessary to break up the large banks in order to create a stable financial system, then we would have to do it and accept the loss of efficiency and functionality that resulted. It is not, thanks in no small measure to the innovation created at the FDIC.
There is no question that financial reforms have made the system much safer than it was, but there is concern that the screws are being tightened too much given the combined impact of all the provisions being put in place. After all, we do want banks to make loans even if that means taking risks. There has to be a balance between safety and the cost of growth. Breaking up the large banks would be a considerable disruption to an economy that is still struggling to achieve sustained growth.
If in the future many financial institutions are failing at once and the financial system is once again teetering on the edge of complete breakdown, the government may be forced to step in as the only entity large enough and stable enough to avoid a massive crisis. That is why Title II of Dodd-Frank provides an important safety backstop. It is not a bailout mechanism. Taxpayers got all their money back in the last crisis and changes to regulation since then would make doubly sure that the owners of the banks would be the ones paying for the losses they incurred.