Saturday, April 22, 2017

The Ying and Yang Regarding Part of Dodd-Frank

In the Wall Street Journal on April 22, 2017 the “Heard on the Street” section had an article entitled “Too Many Questions For Revamp.” In the course of discussing the Treasury’s review of the Orderly Resolution Authority (a provision of the Dodd-Frank law giving government the authority to take over and wind down a failing financial firm) the author, Aaron Back, reports on one view of the pros and cons associated with the decision:

“The debate over this part of Dodd-Frank is one of those strange Washington conversations in which the two sides talk past each other. Conservative Republicans in Congress abhor it, saying it enshrines the concept of “too big to fail” in law by giving the government authority to lend to a failing firm while it is being wound down.”

“But the law’s architects cast it as the solution to “too big to fail.” A government liquidity backstop is provided to a company while it is wound down to make sure its collapse won’t destabilize the financial system.”

It would qualify as honest reporting except that the author is in such a hurry to get to his personal opinion about the issue that he completely overlooks the real substantive source of the disagreement. The author concludes with the statement “Keeping the authority in place makes it riskier to invest in individual financial companies, because the government retains the power to wind them down when it deems it necessary. But it makes the system as a whole safer.” In so doing, the author shifts from reporting to editorializing and ends up not doing either very well. In bankruptcy investors are as much at risk as in an orderly wind down. The power to wind down institutions only creates additional risk for the investor if the government would be inclined to wind down institutions that would otherwise not fail. That would not make the whole system safer.

That brings up one of the real issues behind the difference in policy inclinations. There are legitimate grounds for a difference of opinion about whether the markets or the bureaucrats would be better at identifying failing institutions. Markets will not be made less risky and systemic risk will not be reduced if regulators have a bias toward taking control of institutions they think are at risk. I have a lot of respect for the people I dealt with at the regulatory agencies, but they are definitely excessively risk adverse. They’re paid to be risk adverse. I bet they'd be the first to admit that they are risk adverse.

One of the complaints of the populists of both left and right is that the government was “bailing out” a lot of the big banks. Many of those banks were not at risk of failing, but risk-adverse bureaucrats intervened with liquidity anyway in the name of maintaining orderly markets.

Providing liquidity to maintain an orderly market is quite different from taking over an institution that is failing. It's a different risk, but it is not clear that when regulators intervened they were clear about whether they were making an institution viable or making a market more orderly. But regardless of which risk they were responding to, they were displaying heightened sense of risk aversion. When one goes beyond the risk-adverse bias of the bureaucracy and look at politicians, the situation is even scarier. One of the concerns is that power-hungry politicians like Bernie Sanders and Elizabeth Warren would use Dodd Frank authority to take over banks. It's an issue the author completely ignores, and it's definitely a serious issue.

A second real issue is a substantive difference of opinion about what should be done with banks that are at risk of failing. On the right, the opinion is they should be forced out of business. On the left, the opinion is that management of them should be taken over by government. Which of those options would make the system safer is not a foregone conclusion. One can reasonably argue that the failure of Lehman was disruptive, not because it was a bankruptcy, but because it created a liquidity crisis. Once the liquidity crisis was addressed, the bankruptcy proceedings related to Lehman ceased to be disruptive.

A disclosure is in order. Nothing said above should be interpreted as a criticism of the policies that regulators took during the financial crisis. They made profitable investments that provided liquidity and a guarantee of liquidity exactly as they should.

“Too-big-to-fail” is a legitimate issue worth considering. However, as is explained in some detail in an October 17, 2015 posting entitled “Getting History Right,” the financial crisis hardly justifies the view that regulators lack adequate authority. A simpler approach would be to acknowledge that regulators handled the financial crisis appropriately, and then to clarify any areas where they felt they were going beyond their mandate. But alas, that requires giving up the “bailout” mischaracterization that both the left and the right are so fond of.

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