Economics, Financial Services

Obama is vulnerable for extending Too Big To Fail beyond banking

Barack Obama and Ben Bernanke

Photo Credit: Pete Souza

The fact that some banks are now too big to fail (TBTF) came up in the first presidential debate, when Romney observed that this was one of the most serious failures of the Dodd-Frank Act. But in the debate tomorrow, Romney should point out that the Dodd-Frank Act actually extends TBTF beyond banking into other financial industries where it has never existed before.

No one likes TBTF, and for good reason. When a financial institution is TBTF it is able to attract funding at favorable rates. This is because its creditors believe that the government will make special efforts to assure that the institution remains stable. And if it fails, there is a good chance that the government will step in to protect its creditors, as occurred for example with Bear Stearns, AIG, and Fannie Mae and Freddie Mac. Both these elements create serious dangers for a competitive financial system. The advantages that TBTF provides to large institutions threatens the survival of smaller ones, as Romney noted in the case of banks.

Given the consensus that nothing good can come from TBTF institutions, it is remarkable that there has been no significant commentary about news reports last week that the Financial Stability Oversight Council—a group of federal financial regulators constituted as an uber regulator by the Dodd-Frank Act—is getting ready to designate certain large nonbank financial institutions as “systemically important” and to subject them to special regulation by the Federal Reserve.

These designations, when they occur, will be based on a judgment by the Council that the failure of one or more of these institutions—large insurance companies, and at least one finance company—could cause instability in the US financial system if they fail. In other words, it will be a statement by the government that they are TBTF.  This action will extend the TBTF problem beyond banking for the first time, and provide these firms with the same advantage over their smaller competitors that the TBTF banks have over smaller banks.

What is remarkable is that Romney has not cited this fact in his indictment of the Dodd-Frank Act. He is certainly correct that the act did nothing to prevent the development of TBTF banks, but in this case Dodd-Frank is actually extending TBTF to other sectors of the financial system.

If the subject of financial regulation comes up in the town-hall debate on Tuesday, Romney would be well advised to point out that the Dodd-Frank legislation that Obama pushed through Congress will make the TBTF problem materially worse by spreading it beyond banking to other sectors of the financial system.

3 thoughts on “Obama is vulnerable for extending Too Big To Fail beyond banking

  1. Dodd-Frank will do nothing of the kind, Mr. Wallison. Not that you have any credibility on ANY subject.

    However, once again, we have Romney or some AEI hack complaining how bad a situation is, without the merest hint of a policy idea to cure it. At least D-F does provide that banks draw up their own living will.

    While banks ARE getting smaller thanks to Dodd-Frank: the prop trading desks have been dialed back, to name one example, and Bank of America continues to lay off people in the tens of thousands and Citigroup sheds divisions- no one seems to any concrete idea on how to shrink SIFIs to the point where their failure would not cause a fiscal domino effect. Everyone bellyaches, from Neil Barofsky on, but I never see one concrete proposal that someone can put up and say “Yes, that’s it.”

    The only solution I would see is to undo the mergers and acquisitions that were allowed in the 1994 Gingrich/Clinton “compromise” that allowed banks to gobble each other up. If you’re wondering why banks like Norwest, Marine Midland, Core States, etc. are gone, one reason is due to the rule that prevented, or slowed, interstate expansion. Another footnote in the lead up to the crisis, but an important one.

  2. There’s a difference between creating a problem and recognizing it. Lehmann Brothers was not designated too big to fail. Yet its collapse created such massive shock waves in the financial markets that in hindsight, bailing it out might have resulted in a better overall outcome. (Please note that I am absolutely not claiming this would have been the case, only that it is a reasonable possibility.) Dodd-Frank merely tries to recognize the reality that some firms are in a similar position.

    Now, I will agree that Dodd-Frank doesn’t really solve the problem of an institution being so big that its collapse threatens the entire financial system. It merely attempts to provide more oversight so that problems are detected and corrected before they reach crisis stage. To really fix the problem of a single institution being so big that its failure threatens to bring down the system, you’d have to force a breakup of the large institutions. Is Mr. Wallison actually proposing such a move as a preferable alternative to Dodd-Frank?

  3. While Mr. Wallison makes his impassioned plea for MORE REGULATION, one thing we should keep in mind are the many good reforms in Dodd-Frank. On November 5th, Bank of America will redeem about $5 billion in Trust Preferred Securities. These were instruments bequeathed as a gift to the banking industry, which allowed them to issue preferred shares, with a generous tax credit, and a high coupon payout.

    The joke: The banks were permitted to count this as Tier 1 Capital.

    This is like you getting a home equity loan and calling it an “asset.” Dodd-Frank gives the banks until January 1, 2016 to rid themselves of these instruments. By the way, it WAS possible to follow the law and buy these at a sharp discount to the redemption price, reap a large coupon payment, and get a nice fat gain upon redemption.

    But then, you would have to be me.

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