The Financial Times today carries a story that U.S. banks have been resisting a new Fed regulation—issued under the Dodd-Frank Act—that would limit their credit exposure to one another. According to the article, the banks have data showing that this would reduce credit availability by about $1.2 trillion.
Similar restrictions will apply to all nonbank financial firms—insurers, finance companies, securities firms, hedge funds, and others—that could be designated as systemically important financial institutions (SIFIs) by the Financial Stability Oversight Council (FSOC), a group of federal financial regulators created under the Dodd-Frank Act. If that occurs, these firms will become subject to the Fed’s regulation and credit availability in the U.S. economy will be further restricted.
The Fed’s proposed regulation—like the Dodd-Frank Act itself—is based on the notion that there are “interconnections” among financial institutions that will cause the failure of one large firm to drag down others.
However, events after Lehman’s bankruptcy disprove this idea. With the exception of one money market mutual fund—which probably believed that Lehman would be rescued like Bear Stearns—there is no example of a financial firm that was dragged down or made insolvent by Lehman’s failure. Wachovia, Citibank, Washington Mutual, Merrill Lynch, and AIG all got into trouble through their exposure to subprime and other low quality mortgages, not because of their exposure to Lehman.
If Lehman could fail at a time when large numbers of other firms were weak and seemingly unstable—without this failure having any knock-on effects—it is obvious that the “interconnections” theory that Dodd-Frank and the Fed are pursuing is invalid.
This is another reason why the authority of the FSOC to designate nonbank firms as SIFIs should be repealed before it does further harm to economic recovery.