Is Dodd Ending Too Big to Fail?

by Larry Kudlow

Surprise, surprise. Sen. Chris Dodd’s financial-regulation proposal raises the possibility of substantial progress on the road to ending “too big to fail” (TBTF) and bailout nation for banks and other financial institutions.

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How the Dodd bill will play out in the final details remains to be seen. But when you read the Dodd fact sheet, there are a few key items to like.

First, under the Dodd scheme, large complex companies will have to submit plans for rapid and orderly shutdowns should they go under. These are called “funeral plans.” Then, in terms of these orderly shutdowns, the bill would create an “orderly liquidation mechanism for the FDIC to unwind failing systemically significant financial companies. Shareholders and unsecured creditors will bear losses and management will be removed.” Good.

Then comes the “liquidation procedure.” This spells out that the Treasury, FDIC, and Federal Reserve must all agree to put companies into the orderly liquidation process. “A panel of three bankruptcy judges must convene and agree — within 24 hours — that a company is insolvent,” the bill goes on to say. It also states that the largest financial firms will be assessed $50 billion for an upfront fund that will be used if needed for any liquidation. This is a kind of debtor-in-possession safety net for the bankruptcy-liquidation process. Also good.

Finally, under the heading of bankruptcy, the bill stipulates that most large financial companies are expected to be resolved through the normal bankruptcy process. This is the key. However, it is not an airtight case for bankruptcy. It is possible that a government-resolution process could keep big banks alive or in conservatorship, such as with Fannie and Freddie. That would be wrong. Very wrong. In fact, one of the flaws in the Dodd bill is that there is no mention of Fannie and Freddie.

But the strict language on bankruptcy judges and shutdowns, and the line stating that most large failed financial firms are expected to be resolved through the normal bankruptcy process, is very hopeful.

The biggest flaw in the Dodd bill is that it gives the Consumer Financial Protection Agency (CFPA) far too much free reign. The agency will be housed in the Federal Reserve. But it will be independent inside the Fed, with a director appointed by the president and financed by the Fed’s own profits.

The Fed itself apparently would have no say on CFPA rule-making, which is sort of like giving Elizabeth Warren her own wing at the central bank in order to make mischief. At a minimum, she’ll need grown-up supervision. Many smaller community bankers and non-bank Main Street lenders — such as stores with layaway plans, check-cashing companies, pay-day lenders, and even car dealers — could be put out of business by Elizabeth Warren. (Hat tip to Capitol Confidential of Andrew Breitbart’s biggovernment.com.)

Another issue is the so-called “Volcker rule,” set forth by the White House, which would limit proprietary trading for Wall Street banks, a big source of revenue and profits. Under the rule, it looks like the Federal Reserve or other regulators would supervise any trading limits, but not necessarily eliminate proprietary trading. I think TBTF is terminated under the threat of a true bankruptcy-court liquidation. That’s enough of a disincentive for excess risk-taking to obviate the need for a Volcker rule.

Ditto for the trading of derivatives and other counter-party activities such as credit-default swaps. These are useful hedging devices, although they should be fully collateralized, with clearly valued assets and cash behind them.

Back to the Dodd plan, it also stipulates that the U.S. president appoints the New York Fed president. That’s another flaw. It politicizes the Fed big time. Right now, reserve-bank presidents are chosen and appointed by their boards of directors.

And then there’s a “proxy access” provision that would force public companies to list rival slates for election to their boards of directors. This goes way beyond “say on pay.” And it would permit a bunch of liberal-left, union-type interest groups to spread their anti-business opinions.

However, with the Dodd plan, the possibility remains that a true bankruptcy process will replace government bailouts.

This is vital, since TBTF and government bailouts are among the root causes of the banking crisis, where large financial companies have a moral hazard to take too much risk at taxpayer expense.

The devil will be in the details. And of course, Dodd’s Senate bill will have to reconcile with Barney Frank’s bill in the House. But Chris Dodd conceivably may have opened the door to ending TBTF and bailout nation.


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Posted Mar 17th 2010 at 10:59 am in Congress, Economics, Federal Spending, Obama, Politics | 67 Comments