The Most Damaging Action Taken Under Dodd-Frank

July 19, 2013

It was no surprise that the Financial Stability Oversight Council (FSOC) decided last week to cite a number of nonbank firms as systemically significant, placing them in line for greater regulatory scrutiny by the Federal Reserve. What was a surprise is that (in the midst of a huge outcry in Congress about banks that are too big to fail) neither Congress nor the administration asked the FSOC to stop the designation process until the too-big-to-fail issue had been fully thought through. After all, by designating some nonbanks firms as too big to fail (GE Capital, AIG and Prudential Insurance are in the group) the FSOC has created a whole new set of institutions that will now be considered too big to fail, says Peter J. Wallison, the Arthur F. Burns Fellow in financial policy studies at the American Enterprise Institute.

This is more than peculiar. The legitimate concern of Congress comes from the belief that firms deemed too big to fail have funding advantages over their competitors. The idea that in the midst of this debate the government itself would proceed to make the too big to fail problem materially worse, and extend it to other sectors of the financial system, seems particularly senseless.

Underlying the debate about banks that are too big to fail is the recognition that Title II of Dodd-Frank has failed.

  • That title sets up a resolution system, called the orderly liquidation authority (OLA), for large financial institutions.
  • The framers of Dodd-Frank believed that the source of too-big-to-fail was regulators' fear that allowing a large financial institution to fail would create serious instability in the U.S. financial system.
  • Regulators, they thought, would always choose to bail out these large firms rather than risk the disruption that would follow their bankruptcy.

The OLA was supposed to end these fears by providing an orderly system for winding down large financial firms, allowing the government to seize and liquidate them without concern for adverse consequences in the financial system. The fact that there is still a belief in the markets and in the political class that too-big-to-fail still exists is a demonstration that the OLA is not a credible solution and should be repealed.

What the FSOC has done will be seen in the future as the most damaging action taken under the authority of Dodd-Frank. It has the potential to turn what are today competitive industries into financial sectors dominated by large, government-backed firms, exhibiting all the indicia of crony capitalism.

Source: Peter J. Wallison, "The FSOC Expands 'Too Big To Fail'," The American, July 18, 2013.

 

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