Treasury Disappoints Again on Dodd-Frank – Calls for Supporting Too Big to Fail Firms

COMMENTARY Markets and Finance

Treasury Disappoints Again on Dodd-Frank – Calls for Supporting Too Big to Fail Firms

Feb 28th, 2018
COMMENTARY BY
Norbert J. Michel, Ph.D.

Director, Center for Data Analysis

Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.
Supporting two of the three core elements of Dodd-Frank is not exactly how most people took the President’s comments. mrbfaust/Getty Images

Key Takeaways

The Trump administration deserves credit for stemming the regulatory tide and launching a serious reform agenda.

What remains less clear, however, is whether market participants expect that losses will not be imposed on certain classes of operating subsidiary creditors.

If the goal is to prevent a systemic crisis, then by definition fairness is out the window because some firms are viewed differently than others.

The Trump administration deserves credit for stemming the regulatory tide and launching a serious reform agenda. The administration has blocked and rescinded several rules, withdrawn hundreds of other regulations from the pipeline, and signed 15 Congressional Review Act resolutions.

But the last two Treasury reports on financial market regulation, along with Treasury’s stance on housing finance reform, leave no doubt that the administration will do little to help fix the mess that Dodd-Frank created or to help fix regulatory problems that contributed to the crisis. These reports are puzzling and utterly disappointing – the President promised his administration was “going to be doing a big number on Dodd-Frank.”

Yet his administration now officially supports the Financial Stability Oversight Council’s (FSOC’s) role in stamping out financial system risk (Title I of Dodd-Frank). The latest letdown is that the administration officially supports keeping Title II of Dodd-Frank, known as orderly liquidation authority (OLA), in place.

Supporting two of the three core elements of Dodd-Frank is not exactly how most people took the President’s comments.

It is impossible to fully square this report – or the last one – with the administration’s core principles for regulating U.S. financial markets. House Financial Services Chair Jeb Hensarling was right to call supporting OLA inconsistent with the President’s core principle of ending taxpayer bailouts.

Leaving OLA in place does the opposite of preventing taxpayer-funded bailouts. It is a taxpayer-supported resolution process. This process, like the rest of Dodd-Frank, helps the too-big-to-fail companies and their creditors.

Vice President Pence’s chief economist was dead on when he argued that, under OLA, “The FDIC is allowed to pay 'any obligations.' If you’re bailing out creditors, that’s a bailout.” (Anyone doubting that an OLA resolution might help the largest members of the financial industry should check out the Clearing House Association’s OLA report.)

Treasury’s report tries to have it both ways, calling for bankruptcy reforms long supported by conservatives, as well as leaving OLA in place. The idea, supposedly, is to use OLA (with some reforms) only as “an emergency tool for use in extraordinary circumstances.” (See page 31).

That’s a rather strange position considering that’s exactly what OLA is supposed to be in the first place.

Perhaps the most frustrating part of the report is that it highlights the key flaws with OLA and then relegates them to the background. Page 19 explains that:

A key advantage of the SPOE strategy [the FDIC’s method for using OLA] is that it is aimed at fostering continued viability at the operating subsidiary level by focusing resolution at the level of the holding company parent. This approach has the advantage of minimizing a disruption to the clients and counterparties of the operating subsidiaries that could spread contagion.

In other words, the stated goal of OLA is to wipe out the (parent) holding company so that the operating subsidiary – the actual bank or broker-dealer, for instance – and its creditors can keep moving along as if nothing happened.

Proponents of Dodd-Frank see this outcome as an advantage, but it is exactly why Congress should jettison OLA. It creates a moral hazard problem: It provides every incentive for the operating subsidiary to take on more risk because there is a known backstop.

It is true that all the regulation imposed after the crisis is supposed to tamp down such risk taking, but why should anyone trust the regulators that got everything wrong leading up to the last crisis to get everything right this time?

And, of course, if those regulators really did get all that risk-mitigating regulation right, then there’s no need for anything like OLA. But I digress.

The very same section of Treasury’s report that acknowledges this moral hazard problem also points out:

What remains less clear, however, is whether market participants expect that losses will not be imposed on certain classes of operating subsidiary creditors. If such an expectation were to exist, then SPOE could create a competitive distortion between the operating subsidiaries of firms presumed to be candidates for Title II and those that are not.

It is also possible that the advantage conferred on operating subsidiaries of such firms is not borne fully by the holding company creditors but rather derives from an expectation that government support would be provided to the firm.

The report recognizes that it is difficult “to measure the extent of any such market distortion,” and then calls for further study of this issue “as observable market data from a range of market and credit cycles becomes available.”

But as the folks at Treasury are certainly aware, these market data will always be difficult to obtain because crises are relatively rare and because the operating firms in question generally are not publicly traded. The holding companies that might get wiped out are the ones that are traded, making it exceedingly difficult to measure possible distortions among subsidiaries.

Regardless, this moral hazard/competitive advantage issue is the very core problem with OLA, and Treasury essentially punted. But that’s hardly a surprise.

Treasury’s FSOC report made clear that the administration supports directly using the power of the federal government to prevent “serious adverse effects on financial stability.”

Once that principle drives policy, all the other bets are off.

There’s no need, for example, to worry about ensuring that the FDIC can’t treat certain creditors more favorably than others. If the goal is to prevent a systemic crisis, then by definition fairness is out the window because some firms are viewed differently than others.

The whole concept rests upon treating some firms and some creditors as more important than others.

Nobody wants a financial crisis, but anyone who thinks that Dodd-Frank really protects Main Street over Wall Street is sadly mistaken. That’s why conservatives were so hopeful the President meant what he said about doing a number on Dodd-Frank, and that’s why they’re so disappointed now.

This piece originally appeared in Forbes https://www.forbes.com/sites/norbertmichel/2018/02/26/treasury-disappoints-again-on-dodd-frank-calls-for-supporting-too-big-to-fail-firms/4/#377518301e2a