Dodd-Frank Not Likely to End Bailouts as Promised

Published July 16, 2012

July 21 marks the two-year anniversary of the passage of the Dodd-Frank financial regulatory act. So let us ask: Has the intervening regulatory and industry activity fulfilled the promise that Dodd-Frank will end bailouts?

Bailouts are an attempt to prevent something worse such as the collapse of the financial system. As there is no test to confirm the systemic risk of a financial firm in advance, a regulator will choose taxpayer-funded support of the firm over risking the demise of the financial system.

Although the Boxer amendment to Dodd-Frank prevents the use of taxpayer funds to avoid liquidation of troubled financial firms, Dodd-Frank and its regulatory implementation to date leave plenty of bailout loopholes. Consider three mechanisms: markets with inherent systemic risk, the regulation of firms prior to financial distress, and the resolution of distressed firms.

Repos Ignored

Even in the Dodd-Frank world, firms with critical mass in payments processing, securities settlement, and over-the-counter (OTC) derivative markets retain the systemic risk that fosters bailouts. For example, Bear Stearns OTC derivative positions drove its rescue. Bear was heavily funded with overnight repurchase agreements (repo) and had large positions in credit default swaps. Dodd-Frank ignores repo.

It does require that other OTC derivatives be moved to exchanges for trading, and, thus, third-party clearing in order to isolate the financial system from a future Bear Stearns.  Of course the clearing firm will now be “Too Big to Fail” and will receive Federal Reserve assistance should it get in trouble as the Options Clearing Corporation did during the stock market crash in October, 1987.

However, the exchange trading and clearing requirement as well as the regulation of the clearing organizations themselves will be at the discretion of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) which are tasked with establishing the necessary rules. Although repo will remain a potential reason to bail out a firm due to systemic concerns, relying on the CFTC and SEC to move the remaining OTC contracts to clearing mechanisms is not promising.

OTC derivatives were illegal for 60 years until banks pushed for and received the ability to transact in them during the 1980s as a result of a series of “no action” letters by the CFTC. The SEC was more focused on investigating Harry Markopolos than Bernard Madoff, whose statistically impossible derivative overlay strategy claims first prompted Markopolos to suspect a Ponzi scheme.

Taxpayer Risk

Consider next the regulation of large financial firms. The United States was unique in greeting the Depression-era bank insolvencies with “Glass-Steagall,” the Banking Act of 1933, which separated banking activities of deposit taking and lending from more risky activities of issuing securities such as stocks and bonds. The Banking Act also created the Federal Deposit Insurance Corporation (FDIC) to oversee a system of bank-funded insurance for small savers. Thus, banks were restricted from some activities and also provided with a federally funded safety net.

It is common for the industry to protest the insurance assessments when things are good and the insurance pool looks large, but also common to refrain from punishing the banks during times of stress when the funds are depleted. The savings and loan crisis of the 1980s is a perfect example. For the $150 billion in total losses, institutions paid $25 billion and taxpayers the remaining $125 billion. 

Regulators bemoan the lack of power that hobbles them from addressing crisis events. However, it was the continual “reinterpretation” of Glass-Steagall’s section 20 by the Federal Reserve (with congressional prodding) during the 1990s that made the 1999 Gramm-Leach-Bliley act rescinding it a foregone conclusion. Large banking institutions lobbied hard for these results, frequently using competition and profitability arguments much like those made today to object to a number of proposed Dodd-Frank restrictions.

‘Volcker Rule’

Dodd-Frank’s “Volcker Rule” is a pale effort to restore Glass-Steagall by restricting proprietary trading. This will rely upon regulatory enforcement. The Office of the Comptroller of the Currency (OCC), the regulator of large national banks, has spoken publicly in the last year against the overreach of Dodd-Frank. The OCC also failed to monitor JPMorgan’s trades in a $360 billion portfolio managed in London under the guise of a hedging strategy. Current estimates peg losses in those trades at $6 billion to $8 billion.

Consider also the resolution of a troubled financial firm. The FDIC Improvement Act of 1991 (FDICIA) addresses the regulatory delays, congressional inaction and accounting games that produced the savings and loan crisis in the 1980s. It empowers the FDIC to close institutions promptly and protect taxpayers. The FDIC has been effective in doing this for small banking institutions but not for large ones. The failure of IndyMac cost taxpayers $9 billion in 2008.

Under Dodd-Frank, the FDIC once again must wait for an invitation from the newly created Financial Stability Oversight Council (FSOC) before beginning resolution. From the FDIC’s own announcements it will nurse troubled financial institutions back to life via bridge institutions.

It looks like bailouts are here to stay. Critical markets will provide a path via repo and regulatory inaction. Large banks and their regulators continue to behave in a manner similar to that preceding the crisis. Finally, the FDIC lacks the means to break up and liquidate a troubled institution in a timely manner.

Thomas Jacobs ([email protected]) is an assistant professor of finance at DePaul University in Chicago.