By HAL S. SCOTT
Originally published by Politico on August 5, 2013
Last week, writing in POLITICO, former members of Congress Chris Dodd and Barney Frank touted the fact that the legislation that bears their names now forbids using public funding to keep failing banks in business. “The U.S. federal government now has the power to terminate the lives of large, heavily indebted financial institutions,” they boasted. Ironically, however, Dodd-Frank has made it more likely that the taxpayers will need to rescue firms, because their statute has left us less able to fight contagion.
How so? Dodd-Frank stripped away much emergency Federal Reserve lending, requiring that it be approved by the Treasury. Using this authority, however, will be difficult, as it is now conflated with the politically toxic idea of a “bailout.” Dodd-Frank also stripped away the possibility, short of a joint resolution of Congress, of increased public insurance (as the FDIC provided for transaction accounts during the financial crisis) and guarantees (as Treasury provided for money-market funds and the FDIC did for senior debt).
As a result of all these “reforms,” in the event of a future crisis, liquidity will dry up in a flash. Once contagion spreads, firms that have become insolvent only due to panic will have to be rescued with public money to avoid an economic meltdown.
With strong weapons to fight contagion, we can let a few incompetent firms fail with assurance that their failure will not cause a run on other solvent firms. This basic truth underlies the time-tested use of lender-of-last-resort authority.
Dodd and Frank recognize that the failure of a future Lehman Brothers could cause “massive problems in the economy” and suggest that orderly liquidation is the way to address them. But the FDIC’s orderly liquidation authority does little to stem contagion. First, even if the FDIC commits to protecting short-term creditors of an institution that falls under the OLA, it may be too late to avoid contagion. Short-term creditors will face uncertainty about their fate until OLA is triggered by a far from certain joint recommendation of the FDIC and the Fed that is then approved by the Treasury secretary after consulting with the president. And one thing we know for sure about short-term creditors when facing uncertainty — they will run.
Second, and more fundamentally, the OLA deals with the wind-up of a firm once it has failed. If a financial institution is taken over by the OLA, it is already too late — again, the sparks of a contagious run are already lit. Lehman’s bankruptcy set off a contagious run. It was similar to what happened in 1933, as nonbank firms’ short-term creditors were not insured.
In response to critics who say the Dodd-Frank Act has left the “too big to fail” problem unresolved, Dodd and Frank suggest that Congress would never reverse its anti-bailout course to save a “large, indebted and very unpopular bank.” They seem to be contending that if faced with a choice to avoid contagion and the destruction of the economy, Congress would not rescue a future Lehman. This is a very scary prediction.
They also make the point that if several institutions were to fail simultaneously, a bailout might be required. This is true, particularly without the tools to fight contagion. Dodd and Frank dismiss this argument by saying it didn’t happen in 2008. But what’s to say it won’t happen now? And if it did, one would hope that TARP, the controversial bailout program, would be quickly reactivated. In extremis, taxpayer-funded bailouts are preferable to another Depression (and remember: Taxpayers actually made money from TARP bank bailouts).
Dodd and Frank acknowledge that firms may still get into trouble. Of course they will, as they always have — by making bad loans. What they fail to acknowledge is that our markets need to have confidence that when a bank fails, its failure will not spark widespread contagion.
Institutional death panels will not instill this confidence. Rather, the confidence will come only with restoring and strengthening of the Fed’s lender-of-last-resort authority and the power of the FDIC and Treasury to give guarantees, if there is no alternative. The beauty of deploying contagion weapons in advance is that they then almost never need to be used. By destroying them, Dodd and Frank have made bailouts more likely.
Hal Scott is director of the Committee on Capital Markets Regulation and Nomura professor at Harvard Law School.