TBTF and Dodd Frank

In these last few days before graduation I have found myself with some free time to reflect and read books I have been meaning to read. Two of those books are 13 Bankers by Simon Johnson & James Kwak, and Stress Test: Reflections on Financial Crises by former US Treasury Secretary Timothy Geithner. I got the idea  from a course I took recently at the Harvard Law School: BGP 264: Capital Market Regulation taught by Professors Hal Scott and Robert Glauber. BGP 264 Is a primer in US capital market regulation and the course explores the evolution of regulation focusing on changes adopted in the wake of the 2008 financial crisis. The Dodd–Frank Wall Street Reform and Consumer Protection Act (or Dodd-Frank) was signed into federal law by President Barack Obama on July 21, 2010. It was the US's response to the recession, and sought to–among other things– end the problem of institutions deemed too big to fail (TBTF). Below is a brief response to whether the Act succeeded in stemming this problem.

Dodd-Frank fails to end TBTF because it does not credibly address how to deal with institutions that are already too big to fail. This is also the crux of Simon Johnson and James Kwak’s book, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. If the problem was that these institutions were “too big to fail,” the solution cannot be to make them even bigger. William Dudley, president of the New York Fed in Solving the TBTF Problem[i], writes that “recognition of the costs generated by the Lehman failure led to extraordinary interventions to prevent further catastrophic failures”. These extraordinary interventions included:

·         In March 2008, the US Federal Reserve System (the Fed) exercised its expanded authority under Section 13(3) of the Federal Reserve Act to support the acquisition by JPMorgan Chase of Bear Stearns (Bear), the fifth largest U.S. securities firm[ii].

·         In addition to putting Fannie and Freddie under conservatorship to prevent their default, the Treasury Department (Treasury) agreed to purchase up to $100 billion of preferred stock in each GSE[iii].

·         The Fed also invoked 13(3) and made an emergency $85bn loan to AIG, in exchange for preferred stock and an ownership stake in the firm.

·         Troubled Asset Relief Program (TARP), where the US treasury offered support to such ailing large institutions as Citi Bank (as well as to others less vulnerable in order to remove the stigma associated with such government support).

·         Broker-dealers had trouble obtaining funding themselves so the Fed activated collateral transformation facility through which broker dealers could switch collateral for treasuries and go out and lend using safer collateral.

·         Etc…

It follows therefore that if Dodd Frank did not end TBTF then it most certainly did not end “bailouts” and the government might be called upon to take similar extraordinary measures in the future. Nonetheless, it should be noted that some of the provisions in Dodd Frank make bailouts for the rest of the financial system more difficult. For instance, Dodd Frank makes it illegal to make the Fed’s discount window available to individual institutions as it now requires a system wide approach. This raises the bar for the Fed’s lender of last resort facility. Moreover, the Federal Deposit Insurance Corporation (FDIC), which formerly gave unlimited transaction insurance during exigent circumstances is now required under Dodd Frank to obtain joint resolutions for such emergency acts from the congress. During the financial crisis, the US Treasury backstopped institutions that otherwise would have failed but Dodd Frank has ended this– allowing the TARP program to expire. It could therefore be said that because TBTF remains, the perception of government bailout remains but the ease with which this can be done has been constrained under Dodd Frank.

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[i] Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal

Reserve Bank of New York and Chairman of the Committee on the Global Financial System

(CGFS), at the Clearing House’s Second Annual Business Meeting and Conference,

New York City, 15 November 2012. 

[ii] Financial Crisis Inquiry Commission (Aug, 31, 2010). Governmental Rescues of “Too Big to Fail” Financial Institutions. 

[iii] Ibid.