James Pethokoukis

Again, it isn’t just Republicans making the charge that the Dodd bill does not end Too Big To Fail. So are a quartet of regional Fed bank presidents:

1) Thomas Hoenig of the KC Fed (in a chat with the Huffington Post):

As for Dodd’s treatment of Too Big To Fail, Hoenig said the bill puts too much power in the hands of regulators. “What I worry about [is] if you have a large institution, and it got into very serious trouble and you only have a weekend to take care of it, the procedures under the Dodd bill would make that very difficult,” Hoenig said. “Let’s say you were coming into Monday morning and you didn’t have the ability to get to the judges in time to get this thing approved, and you had to get to another day. What you would tend to do is lend to that institution — if it were not a commercial bank, you would even use the [Fed's] so-called 13-3 authority… and you would lend to it,” he said in a reference to the legal authority that the Fed claimed gave it the power to lend taxpayer money to AIG. “So you would still have it as an operating bank, you would not have taken control of it, not put it in receivership yet, and yet you would be bailing it out. That’s what we have to avoid.
“There’s still this desire to leave discretion in the hands of the Secretary of the Treasury, and while I understand that desire — because you never know what the circumstance is going to be — the problem is in those circumstances you always take the path of least resistance because of the nature of the crisis.

“You don’t want to be the person responsible for the meltdown, so you take the exception and you move it through.

“But if you had a good firm rule of law, and the markets knew… there were no exceptions… you would be in the long run much better off. It does affect behavior,” he said.

2) Richard Fisher of the Dallas Fed (in a speech):

The dangers posed by TBTF banks are too great. To be sure, having a clearly articulated “resolution regime” would represent steps forward, though I fear they might provide false comfort in that a special resolution treatment for large firms might be viewed favorably by creditors, continuing the government-sponsored advantage bestowed upon them. Given the danger these institutions pose to spreading debilitating viruses throughout the financial world, my preference is for a more prophylactic approach: an international accord to break up these institutions into ones of more manageable size—more manageable for both the executives of these institutions and their regulatory supervisors.

3) Jeffrey Lacker of the Richmond Fed (in a CNBC interview with Steve Liesman):

Lacker: The issue of our time has to do with the government safety net for financial firms. And it’s grown tremendously, and containing that, establishing clear boundaries of that, is the number one priority. As I read the Dodd bill and the mechanism it sets up for the resolution authority, it doesn’t strike me that it’s likely to help us there. And in fact, it seems to me like a major danger is that there’s going to be more instability in financial markets instead of less.

Liesman: The Dodd bill allows for a three-bankruptcy judge panel to declare insolvency. It allows losses to go to unsecured creditors; it allows management to be replaced and shareholders to be wiped out. How much clearer could the government be in this bill that there will be real losses to investors?

Lacker: It allows those things, but it does not require them. Moreover, it provides tremendous discretion for the Treasury and FDIC to use that fund to buy assets from the failed firm, to guarantee liabilities of the failed firm, to buy liabilities of the failed firm. They can support creditors in the failed firm. They have a tremendous amount of discretion. And if they have the discretion, they are likely to be forced to use it in a crisis.

4) Charles Plosser of the Philly Fed:

In order to end TBTF, we must have a way that credibly convinces large financial firms and the markets that firms on the verge of failure will, in fact, be allowed to fail. If the resolution mechanism is either too vague or allows for too much discretion by regulators or Congress to rescue firms through subsidies or bailouts, then troubled firms will surely argue that the risks of failure are so severe and systemic that they must be bailed out. This is what we saw in the recent crisis. A credible commitment by government not to intervene or bail out firms must be the centerpiece of the resolution mechanism.

I believe the best approach to making such a credible commitment and thus ending TBTF is amending the bankruptcy code for nonbank financial firms and bank holding companies, rather than expanding the bank resolution process under the FDIC Improvement Act (FDICIA). While the Senate bill has tightened up the proposal with a stronger bias toward liquidating a troubled firm, the bill would still give a great deal of discretion to policymakers to avoid the discipline of a bankruptcy court. I recognize that the current bankruptcy code does not adequately address the inherent challenges in liquidating large financial institutions without risks to the market, but I believe a modified bankruptcy process would eliminate discretion and strengthen market discipline, by permitting creditors as well as regulators to place the firm into bankruptcy when it is unable to meet its financial obligations.

A few observations, comments and highlights:

1) Three things can happen today, as I see it: a) Chris Dodd and Richard Shelby reach a deal; b) Dems pick off a few Rs, get cloture, and the debate on the bill proceeds; or c) no deal, Rs stay unified and negotiations continue. Of those “c’ is the likely option — and that will eventually lead to a bill that may be getting tougher by moment. On Good Morning America today, Shelby seemed supportive of tougher derivatives language. And although it will not be in the bill, Kent Conrad’s comments that a bank tax is coming is reflective of the growing anti-Wall Street mood on Capitol Hill.

2) An interesting piece in The American by economist Phil Swagel, formerly of the Paulson Treasury Department, on whether the Dodd bill is a “bailout bill.” Read the whole thing, but in this bit he uses Lehman Brothers as an example:

In the fall of 2008, the Lehman Brothers bankruptcy was followed by severe negative effects as short-term credit markets shut down. This is sometimes taken as evidence that bankruptcy is not a tenable outcome for a large financial firm. This is wrong. The disruptions that followed Lehman’s collapse were greatly magnified by the idiosyncratic problem that a large money-market mutual fund broke the buck as a result of losses on Lehman debt. This sparked a panicked flight out of money-market mutual funds, which led commercial paper markets to seize up and in turn begat TARP. This situation would have been prevented only by guaranteeing Lehman debt—that is, by a bailout that the administration says would not be allowed to occur under its financial regulatory reform proposals. This means that either the administration intends to allow bailouts or that its approach would not in fact solve the problem of Lehman’s collapse—it cannot be both ways. In fact, the Dodd bill allows two forms of a bailout, since the government can put cash directly into a failing firm or guarantee its debt. The Dodd proposal is a bailout bill, plain and simple.

3) Here is Charles Plosser, head of the Philly Fed, on Dodd and TBTF:

I believe the best approach to making such a credible commitment and thus ending TBTF is amending the bankruptcy code for nonbank financial firms and bank holding companies, rather than expanding the bank resolution process under the FDIC Improvement Act (FDICIA). While the Senate bill has tightened up the proposal with a stronger bias toward liquidating a troubled firm, the bill would still give a great deal of discretion to policymakers to avoid the discipline of a bankruptcy court.

The Senate bill’s proposal to restrict the Federal Reserve’s supervisory authority to about 35 of the largest financial firms with $50 billion or more in assets further undermines the effort to end TBTF. The markets will likely interpret this provision as signaling that these firms are unique and will continue to be treated as TBTF. Many would assume that the language in the resolution section that emphasizes bankruptcy would not apply to these firms. This provision would, de facto, make the Federal Reserve supervisor of the firms deemed TBTF.

In addition, restricting the Federal Reserve’s supervisory authority to these large firms would focus the Federal Reserve’s attention more toward Wall Street and less on Main Street.

As HuffPo puts it:

A coalition of former regulators, left-leaning economists and Democratic insiders have slammed the Senate’s version of regulatory reform in a letter to the parties’ two leaders, warning that the current bill won’t prevent a future financial crisis.

One of the signers is liberal think-tank economist Dean Baker. I e-mailed him and asked about the letter’s claim that the Dodd reform bill does not “eliminate a perpetual system of government sponsored corporate bailouts financed by the government or private industry.”

His speedy response:

To my view, the biggest failing is that it does not end TBTF banks. As a practical matter, I really doubt that any regulator is going to stand up to Goldman, Citi or any of the other big banks and tell them they can’t do something that is making them lots of money, but poses serious risks to the system. It would have helped if we had fired Bernanke, so that regulators understood that there was downside risk from failing to do their job and crack down on the big banks when necessary. But if Bernanke can get reappointed, even after allowing the worst economic disaster in 70 years, there is little hope that future regulators will take large personal risks to confront major banks when there is no downside to ignoring their practices.

Tyler Cowen gives it his best shot and ends with this recommendation:

If you do wish to break or limit the power of the major banks, running a balanced budget is probably the most important step we could take. It would mean that our government no longer needs to worry so much about financing its activities. Of course such an outcome is distant these days, mostly because American voters love both high government spending and relatively low taxes.

The wonderful Nicole Gelinas explains why she does not think the Dodd bill ends TBTF (as outlined by me):

1) Title II, which starts on p. 107, explains how “orderly liquidation authority” would work. When the Treasury and a panel of judges have determined that a financial firm is unsafe for bankruptcy, the FDIC would take over that firm. In “liquidating” the company, the FDIC would figure out who — of the firms’ lenders, other creditors, and shareholders — would get what. On the repayment list is “any amounts owed to the United States, unless the United States agrees or consents otherwise” (italics mine). That speaks for itself on whether taxpayers will be “exposed to a penny of risk of loss.”

2) More important, though, what does it mean to “liquidate” a company? … The bill does not ensure that lenders will take losses. Instead, it merely directs the FDIC to operate under a “strong presumption” (p. 131) that “creditors and shareholders will bear the losses of the financial company” (p. 132).

3) A hundred-odd pages later, the bill offers a big loophole for lenders in a crisis. It says that the FDIC, “with the approval of the [Treasury] Secretary, may make additional payments or credit additional amounts to or with respect for the account of any claimant or category of claimants of the covered financial company” — that is, to lenders — “if the [FDIC] determines that such payments or credits are necessary or appropriate to minimize losses” to the FDIC (p. 241). It wouldn’t be unreasonable for a lender to expect the government and the FDIC to use all of the discretion the bill affords them to guarantee financial firms’ debt in a future systemic financial crisis, just as happened this time around.

4) Finally, Geithner’s language — he wants to “dismember” failed financial firms “safely” — is interesting. Three months ago before Congress, Geithner had this to say about the AIG bailout: “We didn’t rescue AIG. We intervened so we could dismember it safely.” True, that was the government’s intent in the fall of 2008. But AIG is still with us; the stock trades at nearly $40.

The timing of the Securities and Exchange Commission’s suit against Goldman Sachs may sway a few doubters. But U.S. financial reform is still partly a matter of faith. That’s one reason for the partisan bickering. Preventing future government bank bailouts relies heavily on Wall Street believing new rules will be enforced and failures will be allowed. For skeptics, though, the current Senate bill leaves enough wiggle room to induce doubt.

On paper, Democrats have a case to support their convictions. Their bill gives regulators new authority to wind down non-bank financial institutions. Tougher new capital and leverage requirements, as well as limits on risky activities, are supposed to make failures much less likely. A $50 billion bank-financed pool would fund resolution costs — though this whole idea may yet be dropped.

The trouble is, teetering banks and their creditors might still assume that while not too big to sue — as Goldman can attest — Uncle Sam would still think them too big and interconnected to fail. And that’s the problem for many Republicans. The bill tends to favor discretion over hard and fast rules. While the feds would have the authority to shut down institutions, for instance, they wouldn’tbe required to do it. History hints that regulators and politicians will continue to be tempted to rescue banks in a crisis, a point made by several regional Federal Reserve Bank presidents who doubt the efficacy of the Dodd bill.

And those new rules on capital, leverage and risky activities will be spelled out only later by a new systemic risk council. The government would be able to guarantee financial firms’ debt without any automatic triggering of the resolution process. And it’s still fuzzy how the challenge of winding down cross-border obligations and operations would be met.

There’s an argument for leaving less to officials’ discretion. If the threat of liquidation isn’t credible, banks will operate — and investors will treat them — as if a government backstop still existed.

If the Democrats’ reform bill passes in its current form, believers might then look for signs that it’s working. One would be that big banks can no longer fund themselves so cheaply. Especially since the recent crisis, big banks — with, say, more than $100 billion in assets — have been paying less interest on deposits and debt than smaller brethren.

If that too-big-to-fail subsidy doesn’t narrow significantly, Republicans would be justified in calling for a reform revival.

Former Bush WH deputy press secretary Tony Fratto gives it his best shot:

Over the decades, large, complex financial institutions —big banks— have been unquestionably beneficial to the U.S. economy, and to the global economy. Big banks efficiently facilitate cross-border trade and investment on a global scale, resulting in benefits that have consistently accrued to consumers and improved standards of living for people in all markets.

Large U.S. financial institutions have also contributed to the development of deep, liquid capital markets here in the United States, ensuring unique access to global financing for U.S. firms. Scale and scope are needed to sustain global trade and finance, and big U.S. banks are leaders in delivering those services.

There are ways to increase the safety and soundness of big banks – to prevent the kind of explosion we saw with Lehman Brothers, but breaking up our big banks is the wrong way to go. Initiatives to raise capital levels, improve capital quality, decrease leverage and improve liquidity – across the entire global banking system – make sense.

Me: But I guarantee you that plenty of GOPers in 2010 and perhaps the 2012 nominee are going to call for breaking up the banks and paint the Ds as the party of Wall Street. The party will not be pro-Big anything