One Year After Dodd-Frank, Bailout Dilemma Remains

Published August 8, 2011

Ever since the bailout of Continental Illinois Bank in 1984, bank bailouts have been an unpopular device for protecting the financial system from risks posed by troubled banks deemed “too big to fail.”

Many taxpayers believe bank bailouts are an abuse of taxpayer funds, especially when bank managers are allowed to keep their jobs, stocks, severance pay, and pensions. Free-market enthusiasts, for their part, dislike bailouts because they thwart the corrective action that market forces would otherwise bring about.

Members of Congress have heard these complaints, and the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in July 2010, prohibits taxpayer-funded bailouts. But it also suffers from a fundamental flaw: It leaves the financial system exposed to meltdowns.

New Fed Powers

Among other provisions, Dodd-Frank gives the Federal Reserve new authority to deal with bank and nonbank financial institutions it believes are “systemically important,” meaning firms previously viewed as “too big to fail,” explains New York University Professor of Finance Roy C. Smith in an article for the Summer 2011 issue of The Independent Review.

If the Fed deems an illiquid financial institution poses a “grave threat” to the financial system and warrants special regulatory action, the targeted firm can lobby the Financial Stability Oversight Council to block the Fed from taking action. But by then it may be too late for the targeted firm: Because bailouts are off the table, the market may react to the Fed’s initial announcement with a run on the targeted firm, with undesirable consequences for the rest of the banking system.

“The run will spread instantly throughout the banking industry, as such runs did after the Lehman episode in September 2010, and without the capacity for bailouts several firms rather than only one might end up in bankruptcy,” Smith writes.

Unlikely Actions

Federal Reserve policymakers, of course, are unlikely to take actions they believe would result in the bankruptcies of several of the largest financial institutions.

“The only way to avoid such an outcome in a no-bailout world is never to declare a firm to be a ‘grave threat,’ which means the Dodd-Frank resolution authority almost certainly will never be used except to liquidate a bank the Fed has decided to close down,” Smith writes.

Dodd-Frank is also flawed in other ways, Smith argues. For example, because the law gives federal agencies new powers to scrutinize and regulate large financial institutions, riskier financial transactions will gravitate to smaller, less-regulated institutions.

“The nonbanks that take over these businesses,” Smith continues, “will endeavor not to become large enough to become systetically¬†important under Dodd-Frank.”

In other words, Dodd-Frank is designed to look as if the government has new powers to prevent financial crises, but the fine print reveals a different picture.

Carl P. Close is research fellow and academic affairs director at The Independent Institute.

Internet Info

“The Dilemma of Bailouts,” Roy C. Smith: