Will Dodd's Financial Reform Bill Allow Bailouts?

Perhaps nothing angered the average American more during the financial crisis than the idea that they would have to bear the cost of keeping alive giant financial firms that should have failed. Policymakers, including former Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, said that bailouts were undesirable but necessary. They asserted that the entire financial system would collapse if the government did not intervene. It's impossible to know if that claim was true, but Congress wants to make sure that the question of whether to bail out a firm never has to be asked again.

Yet, Republicans are unconvinced that the financial reform legislation offered by Senate Banking Committee Chairman Christopher Dodd (D-CT) would really end bailouts. In a fiery exchange of floor speeches this week, he and Senate Minority Leader Mitch McConnell (R-KY) debated this point. Dodd asserts that his bill will put an end to bailouts, while McConnell and other Republicans say it leaves the door open for the government to prop up firms in perpetuity. Who's right? They both are.

The Problem

Dodd's bill seeks to create a mechanism for winding down firms that are so large or interconnected that their failure could cause the financial system to collapse. The so-called too-big-to-fail problem was the basis for rescuing firms like AIG and Fannie Mae. Such institutions enduring regular bankruptcy proceeds would have taken too long, creating an extended period of uncertainty and market turmoil. The creation of a non-bank resolution authority -- with a similar role to that the FDIC plays with troubled depository institutions -- could help.

But quickly and cleanly liquidating giant failed firms won't be easy. So merely providing this authority to a government regulator isn't enough. What happens if losses to creditors and counterparties threaten to further weaken the financial system? To alleviate this pitfall, Dodd has included a $50 billion liquidation fund to cover those costs, which will be paid for through proactive assessments on the very firms that the fund could be used to wind down.

And therein lies the problem: the liquidation fund would likely provide those firms a distinct advantage. The American Enterprise Institute Financial Policy Scholar Peter Wallison explains this objection in a blog post today. What are these "costs" that the $50 billion fund will be used to cover? He believes it will serve to pay off creditors, "so that the market's fear of a general collapse will be allayed." Even if creditors don't benefit, other vendors or counterparties who do would provide an advantage to firms that are covered by the fund in a failure event.

Wallison has a fair complaint. Even though the resolution authority may, ultimately, wind down these big failed institutions, it may still bail out creditors -- and that's a problem. This will result in the firms on the government's list of systemically risky firms having cheaper borrowing costs than smaller firms, since their debt will be perceived as safer. Creditors could be fairly certain that they'll get some of their money back if a big institution fails. Large firms will have a competitive advantage over smaller ones.

Some Solutions

This isn't an easy problem to fix, but the Senate can take one of several measures to attempt to do so:

Provide Clarity on Costs

Dodd might gain some political points if he explicitly defines the "costs" that the liquidation fund could cover. Then, if any of those costs are objectionable -- like using the fund to pay off creditors -- they can be crossed off the list. The problem here, however, is that it's hard to imagine that the resolution authority can accomplish its mission without some flexibility in deciding which costs must be paid to achieve market stability. If you define costs too liberally, then you end up with a bailout-like feel; if you define costs too conservatively, then the resolution authority is ineffective. More on this issue here.

Let All Firms Utilize the Liquidation Fund

Dodd's bill has a problem because it could provide big firms with an advantage, since only their failures utilize the liquidation fund during wind down. Why not, instead, allow all firms equal access to the fund for whatever costs it would have covered for only the large institutions? Think of depository insurance here. The FDIC does not provide only some banks with a competitive advantage because all participate. All pay assessments, and all get the benefit of depository insurance. Why not do the same for the liquidation fund? More on this solution here and here.

Create Financial Utilities

Another possibility would be to sort of meld together the two options above. Define which kinds of obligations or transactions must be protected to prevent a financial system-wide panic. Then guarantee these aspects of business for all firms. More on this here.

Whatever the Senate decides, the contention that the government should do nothing if a very large or interconnected firm fails is not a legitimate solution. The collapse of Lehman Brothers demonstrated just how ugly things can get -- it triggered a financial crisis leading to 20% underemployment. Even if whatever steps taken with financial reform do not result in a perfectly safe financial system -- and they likely can't -- they should at least seek to lessen the severity of major market disturbances like those experienced during the recent crisis.