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GRAY: ‘Too big to fail’ casts a long shadow
Question of the Day
As we approach the fourth anniversary of 2008's financial crisis, it's clear that Congress has done nothing to solve the crisis's central problem.
Today, as then, certain financial institutions are "too big to fail," a state of affairs that benefits those companies but imposes great risk upon the economy at large. The Dodd-Frank reforms of 2010 purported to solve this problem, but they worsened it. And the latest whistleblower is none other than the Dallas Federal Reserve Bank.
Let us briefly review history. In 2009 and 2010, Congress and President Obama debated financial reform in the shadow of massive government bailouts - the Troubled Asset Relief Program, the subsidization of JPMorgan's takeover of Bear Stearns, and the rescue of AIG (or, more accurately, AIG's counterparties).
As Roger Lowenstein recounts in "The End of Wall Street," the issue of too big to fail, which Federal Reserve Bank Chairman Ben S. Bernanke called a "top priority for reform," hung over Washington like a dark cloud. The crisis had bequeathed precisely the "moral hazard" that Treasury Secretary Henry M. Paulson Jr. had feared. "Post-crash, markets presumed that the government would, if necessary, bail out important banks. This meant that big banks could borrow on favorable terms (since the government would not let them fail.)"
So did Congress solve this problem? Astonishingly, no. Dodd-Frank talks tough, purporting to end taxpayer-funded bailouts, but as the Dallas Fed's new annual report explains, "words on paper only go so far." Dodd-Frank's "pretense of toughness" cannot stop the president, Treasury secretary, or Federal Reserve from taking dramatic action to bail out major banks when the next crisis hits. "For all its bluster," the Dallas Fed concludes, Dodd-Frank leaves the principle of too big to fail entrenched.
If anything, the Dallas Fed's criticisms are too gentle. Dodd-Frank does not just entrench too big to fail - it exacerbates it. Dodd-Frank created the Financial Stability Oversight Council to identify financial institutions that could, in a crisis, "pose a threat to the financial stability of the United States." In other words, the council will officially deem financial institutions too big to fail, signaling that the government will not allow these indispensable companies to fail.
And that creates the very moral hazard that Mr. Paulson feared. Believing that the government will have no choice but to bail them out if things go wrong, the government-designated companies have little reason not to undertake even riskier activities: if they hit the jackpot, they keep it; if they bust, the government will ride to the rescue.
Under Dodd-Frank, troubled too big to fail institutions are subject to "liquidation" - the Treasury secretary condemns the company and hands it over to the FDIC to fix or dismantle it, with virtually no judicial review.
The government will pay for these liquidations not through congressional appropriations, but by imposing fees on other financial institutions. So while Dodd-Frank's backers make much of the fact that taxpayers will not pay for bailouts, they neglect to note who will pay for them: everyone who owns stock in financial institutions.
Worse still, that process gives the government immense power to pick and choose winners and losers. Dodd-Frank empowers the government to favor certain stakeholders and disfavor others, just as it did in the Chrysler bailout. The Obama administration made sure to protect its friends in the unions, but it forced others - especially Indiana's state pension funds for teachers and state workers - to swallow millions of dollars of losses in what Indiana Gov. Mitch Daniels later called the "Chrysler cramdown."
And we can only expect more of the same in the future. As law professor David Skeel observes in "The New Financial Deal," Dodd-Frank's two central themes are "government partnership with the largest financial institutions and ad hoc intervention."
Dodd-Frank does not promote good government and sound capitalism; it increases and consolidates government power without checks and balances. The winners are federal power brokers, crony capitalists, and liberal interest groups. The losers are the rest of us.
• C. Boyden Gray served as White House counsel in the administration of President George H.W. Bush.
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