The Future of Bailouts and Dodd-Frank after the 2012 Election

November 2, 2012

The Dodd-Frank Act (DFA) has received little attention this election cycle despite being a hot-button issue in 2010. Originally a response to the financial crisis, the DFA will have implications for the economy for many years to come, says Peter J. Wallison, the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

  • The DFA sought to end financial bailouts and too big to fail firms.
  • However, only tax-funded bailouts have ended; creditors can still provide bailout money.
  • This creates a moral hazard effect by creating the perception among investors and creditors that lending to large firms is a safer bet compared to small ones because the large ones are considered too big to fail.

The DFA imposed regulations on banking organizations that had $50 billion in assets or more because they comprise the health of the entire U.S. financial system. However, many creditors have taken this as a sign that the government has dubbed these banks as too big to fail and thus created a moral hazard by incentivizing creditors to lend to large firms.

This places smaller firms at a disadvantage. Smaller firms don't get the benefit of lower borrowing costs from the implied government support. Instead, creditors will pump large amounts of money into large firms. Because of this, a small Texas bank challenged the DFA on constitutional grounds arguing that it creates an uneven competitive environment.

Title II of the DFA creates the Orderly Liquidation Authority (OLA), which allows the secretary of the Treasury to seize any financial firm if that might fail and cause instability in the U.S. financial system. Furthermore, the FDIC is allowed to bailout the firm's creditors once it is taken over by the Treasury, which once again creates the potential for a bailout.

The DFA also requires that most swap transactions be cleared through independent clearinghouses. But because of the risk that these clearinghouses can default, the DFA also designated them to be important to the financial market and thus eligible for the Fed's financial support when they can't meet obligations. This creates another moral hazard because parties will be less concerned about its financial position and encourage more risk when making deals because the government will be available to bail them out.

Source: Peter J. Wallison, "Too Big to Ignore: The Future of Bailouts and Dodd-Frank After the 2012 Election," American Enterprise Institute, October 24, 2012.

 

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