Dodd-Frank, Bailout Reform, and Financial Crisis Ambiguities

BY PETER GRUSKIN

The financial crisis of 2007-2008 forced U.S. President Barack Obama and his administration to reconcile with the need to “re-regulate” the financial markets. According to the president, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act gave the administration much of what it was seeking, but the legislation has also left many unanswered questions. Are taxpayer funds really safer today as compared to before the last big financial crisis? More broadly, have the legislative measures given adequate consideration to systemic risk in financial markets?

A White Paper for Reform

In order to better understand these questions, it is worth reviewing the administration’s intentions when it came to re-regulating Wall Street. In June 2009, the administration issued a white paper, which listed the following “asks”:

 (ii) new authority for the Federal Reserve to supervise all firms that could pose systemic risk . . . (iii) stronger capital, liquidity and other prudential standards for all financial firms and yet-higher standards for [firms that could pose a systemic risk] . . . [and] (ix) the reporting of information by [hedge fund and private equity fund] advisers about their managed funds to enable an assessment of whether these funds pose a risk to financial stability.[i]

In response to these proposals, Chairman of the Senate Banking Committee Christopher Dodd and Chairman of the House Financial Services Committee Barney Frank took the lead in crafting legislation that came to be known as the Dodd-Frank Act.

Because of the persistent structural restrictions on further reform (such as a lack of bipartisan political will on regulatory issues), Dodd-Frank may be the best outcome that the U.S. political apparatus can offer in response to the president’s asks. In fact, Obama has maintained that Dodd-Frank “represents ninety percent of what I proposed when I took up this fight.”[ii]

Aligning Incentives

Despite Obama’s statement, the legislation is not easy to lock down, as much of it will be more clearly defined or redefined in the coming years. Consider, for example, the complicated provisions allowing for federal regulators, including the U.S. federal bank insurer—the Federal Deposit Insurance Corporation (FDIC)—to take control of a financial firm in danger of failing, one that already has been deemed insolvent, or one that poses a “systemic risk” to the financial system (as defined by regulators). This is one of the most important provisions in Dodd-Frank and is one that gives broad new powers to the FDIC. According to Federal Reserve Chairman Ben Bernanke, these new powers, and the bill as a whole, work to ensure that the public need not worry about future bailouts of “too big to fail” firms that put taxpayer money at risk. However, the takeover criteria outlined above have not been precisely defined. 

Furthermore, should a firm fail despite the government’s intervention, the contingency plan is to finance a future bailout with another source of funding. The federal government can now recoup any taxpayer loss by levying fines on surviving financial institutions. Skadden, Arps, Slate, Meagher & Flom LLP, a law firm that advises on mergers and acquisitions, summarizes the provisions relating to payback, as supervised by the FDIC:

The Act prevents the use of taxpayer funds to pay for the receivership process. It provides that “no taxpayer funds shall be used to prevent the liquidation of any financial company”; “taxpayers shall bear no losses from the exercise of any authority under this title”; “creditors and shareholders must bear all losses in connection with the liquidation of a covered financial company”; and that the FDIC shall not take an equity interest in any covered financial company. Moreover, the Act provides that “[a]ll funds expended in the liquidation of a financial company under this title shall be recovered from the disposition of assets of such financial company,” or shall be recouped via assessments on other financial companies.[iii]

As conceptualized, the president’s re-regulation effort gives the taxpayer a high priority for payback of a government-funded loan. These stipulations, however, do not make the system less prone to systemic crisis. And in the absence of eliminating systemic risk, which is not really possible, we cannot fully shield ourselves from the possibility of having to bail out the big financial firms again. The next question, then, is how the intervention will play out.

Further entangled in this debate is the question of whether “moral hazard” has been reduced by the new financial market regulations. Moral hazard is an incentive mismatch connected to the too-big-to-fail phenomenon and occurs when firms receive bailout funds or guarantees (insurance) whose cost is not fully realized by them. This setup might lead the financial decision makers (management, shareholders, creditors, traders, etc.) to take more risk in the future than they otherwise may have taken since the consequences of bad investment decisions have been partially eliminated. In other words, if actors know that they are likely to be bailed out in the event of an institutional failure, they assume outsized market risk on that basis. Asymmetric incentives also arise on the trading floor, since traders’ incentives are not always perfectly aligned with those of the institution.

If Dodd-Frank hasn’t sufficiently addressed moral hazard and the risky behavior of financial entities, the public should continue to worry about the stability of the financial system during the next crisis. Dodd-Frank does try to make bailouts less likely by communicating to large financial firms that they won’t be rescued again in the hopes that this will lessen the risky behavior. Ultimately, though, no legislation can make financial markets perfectly “safe. 

You Can Resolve Companies, But Not the Future

So how does Dodd-Frank begin to address systemic risk? It allows regulators such as the Federal Reserve, the FDIC, and the Financial Stability Oversight Council (FSOC) to review and exercise more control over financial companies, which they can identify as systemically important. This puts the institution in a category (on a too-big-to-fail list) of companies that the government can then further monitor and, if appropriate, assist, although Dodd-Frank places restrictions on how this is to be done.

This to-be-fully-determined federal resolution process may be initiated when the U.S. Treasury secretary asks for the boards of the Federal Reserve and the FDIC to vote on resolving a company (this is the general procedure for most financial companies). Under Section 203 of Dodd-Frank, the three agencies listed above can turn their respective “keys” and trigger the process of taking over a financial company in or near default.[iv] Two-thirds of the Federal Reserve’s Board of Governors and two-thirds of the FDIC’s Board of Directors must elect to resolve the company, and presidential consultation is also required. The process receives judicial oversight through a secret twenty-four-hour review by a Washington, DC, court, which is instructed to strike down the process only if the Treasury secretary’s decision was “arbitrary and capricious.”[v] This standard is “very deferential to the secretary and effectively presumes the validity of the secretary’s determination,” according to an analysis of Dodd-Frank by Skadden, LLP.[vi]

Bankruptcy expert David Skeel goes further in his language to portray this process as possibly unconstitutional and unfair to the firms, because they have little judicial recourse.[vii] Skeel’s assertion that the FDIC has almost complete control over the resolution proceedings is useful. It explains how some believe President Obama’s financial re-regulation affirms the government’s “bailout rights” while others believe the exact opposite: that Dodd-Frank has eliminated the possibility of taxpayer-funded bailouts altogether. It all depends on how the FDIC and others will interpret their new mandates.

Again, a prediction of outcomes seems elusive. As with any risk-mitigation attempt against catastrophic financial events, one will probably not know if things have worked out well until the event. More will be left up to the government in a future FDIC resolution process, but it remains unclear how much regulators will punish or reward the private sector for taking on excess risk, for example, by lobbing more systemic-risk taxes on them, by reducing too-big-to-fail insurance, or by keeping the firms afloat. All options have their costs.

Should Dodd-Frank have gone farther to mitigate the possibility of crisis? Regulators cannot necessarily properly monitor financial innovations in time to pick up on the risks inherent in them. Imperfect oversight and incomplete information reduce the capacity of regulators to manage crises. As we have seen, the success of financial regulation turns as much on the capacities of the regulator as on the fickle and evolving nature of the global financial markets.

You Can’t Model the Model Error

Nassim Taleb, distinguished professor of risk engineering at New York University’s Polytechnic Institute and former derivatives trader, gives insight into this confusing nature of market crises and “model error.” A main theme of his book Fooled by Randomness is finding amusement in the human inability to predict. This lack is the result of various cognitive biases,[viii] such as our perhaps innate inability to understand “tail risk” (i.e., the tails of the bell curve are where statistically unlikely events live) in financial environments and elsewhere. The risk of a very small probability event was simply not properly accounted for in most derivatives models pre-crisis.[ix] So will it be satisfactorily dealt with by Dodd-Frank?

This article has sought to shed light on that question. The basic conclusion is that humans cannot control financial markets to their liking, so Dodd-Frank should not reassure us too much. Applicable to the future of bankruptcy and bailouts is the other side of Taleb’s coin: the reflection that humans have a propensity to think they can predict the future regardless of their success in this venture in the past. This may translate to overconfidence in the new regulatory regime when it comes to “predicting” the future course of bailouts, which, as we have seen, is not really possible. International efforts to make the system safer, such as Basel III, should be regarded similarly.

At the end of the day, it is probably too early to tell if Dodd-Frank will avert catastrophe or if a too-big-to-fail institution will be tackled with a heavy hand in the next bankruptcy showdown. Indeed, it may always be too early to tell. That is, until the next crisis strikes.

 

Peter Gruskin received his master’s degree in international economics and international relations from the Johns Hopkins School of Advanced International Studies. He maintains and trains on macroeconomic databases in the Middle East department of a Washington, DC-based multilateral organization.

 

 



[i] Milbank, Tweed, Hadley & McCloy LLP. 2009. The Obama White Paper on financial regulatory reform. Client Alert, 19 June.

[ii] White House Office of the Press Secretary. 2010. Remarks by the president on Wall Street reform, 25 June.

[iii] Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates. 2010. The Dodd-Frank Act: Commentary and insights, 12 July.

[iv] Dodd-Frank Act § 203(b).

[v] Dodd-Frank Act § 202(a)(1)(A)(iii).

[vi] Skadden, 2010.

[vii] Skeel, David. 2011. The new financial deal: Understanding Dodd-Frank and its (unintended) consequences. Hoboken: John Wiley & Sons.

[viii] Taleb provides many examples of the silliness of believing in rigid storylines and models of economic activity. See Taleb, Nassim Nicholas. 2005. Randomness and our mind: We are probability blind. In Fooled by randomness: The hidden role of chance in life and in the market. New York: Random House.

[ix] For more on tail risk and suggestions on how to deal with the skewing of incentives it can cause, see Rajan, Raghuram G. 2010. Reforming finance. In Fault lines: How hidden fractures still threaten the world economy. Princeton: Princeton University Press.