Following the financial crisis, there was a desire to protect the nation against banks becoming so large that their failure would threaten the entire financial system. The result was the Dodd-Frank financial reform act, signed into law in 2010. Now there's a renewed debate over whether the nation's biggest banks are still too big to fail, after Mitt Romney, in the first Presidential debate, called Dodd-Frank, the "biggest kiss that's been given to -- to New York banks I've ever seen." One of the law's co-authors, Rep. Barney Frank (D.-Mass.), hotly disputed that assertion, saying that if a bank "gets into so much debt that they [sic] can't pay off all their debts, they are put out of business" and noted that many firms were resisting Dodd-Frank's implementation.
Last week, Dodd-Frank defenders got a boost thanks to a report produced for the Securities Industry and Financial Markets Association (SIFMA), which argues that Dodd-Frank's "orderly liquidation authority" (OLA) provided what the author called a "meaningful answer to too-big-to-fail," and treats opposition to the law as a mystery.
The law's critics also chimed in. There are, in fact, many aspects of Dodd-Frank that entrench too-big-to-fail status for big banks. As former White House Counsel C. Boyden Gray and attorney Adam White outline them in a Weekly Standard cover story, the new regulatory burdens imposed by the law will place smaller banks at a disadvantage relative to the bigger banks that can better absorb the compliance costs. In fact, some smaller banks may have to merge to deal with the costs effectively, creating yet more big banks in the process.
There's an even more troubling aspect of Dodd-Frank, which Gray and White do not mention. The act designates the too-big-to-fail institutions as SIFIs -- Systemically Important Financial Institutions. SIFIs are subject to additional regulations and eligible for OLA. Most importantly, they have to pay staggeringly large fees to help clean up the mess when a peer SIFI fails. That's right -- Dodd-Frank requires some financial institutions to pay to fix problems created by others.
This means that there are two classes of SIFIs -- 1) the high-rolling institutions that may be tempted to take unreasonable risks with the money people have entrusted to them, and 2) the large stable firms that actually have the money (again, entrusted to them by clients) that can be expropriated by government to pay for the mistakes of the first class. In effect, Dodd-Frank turns responsible institutions into cash cows to pay for the "orderly liquidation" of the irresponsible.
The moral hazard involved in this situation should be obvious. In fact, the OLA and bailout fees together represent an opportunity for regulators to nationalize SIFIs, turning them into new versions of Fannie Mae and Freddie Mac, with all that entails. The idea that Dodd-Frank provides a "meaningful answer to too-big-to-fail" turns out to be a fiction -- and not a very believable one.
This is why responsible institutions have been resisting Dodd-Frank. It's also why state attorneys general are very worried about the damage that this process could do to holdings in state pension funds, which are already under great stress.
Furthermore, the law designates other firms besides banks as SIFIs, including large insurance firms. There is no good reason for this. As State Farm points out, "insurance companies in general, and mutual insurers in particular, do not engage in the types of unregulated, highly leveraged and interconnected activities that threaten the financial stability of the United States (e.g. speculative participation in credit default swaps)." This raises the possibility that regulators could try to broaden the category still further, and designate, say, large retailers and even manufacturers as SIFIs.
It is all so unnecessary. Chapter 11 bankruptcy could provide a perfectly acceptable method for liquidating a bank, as former Federal Reserve Chairman Alan Greenspan noted at the SIFMA meeting last week. However, until Dodd-Frank is repealed or replaced, that will not happen.
Yet, there is another possible solution to the Dodd-Frank mess. The State National Bank of Big Spring, the Competitive Enterprise Institute, and the 60-Plus Association have joined to together to sue over the constitutionality of the law, which creates agencies that violate the separation of powers, among other things. As my CEI colleague John Berlau noted recently, there are now several prominent Democrats who recognize the damage Dodd-Frank is doing. In other words, more and more people are realizing that Dodd-Frank is an example of mystery SIFI theater, and heaping well-deserved opprobrium upon it.