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The Dodd Bill--Skeel

The Dodd Bill—the financial reform package currently under consideration in the Senate—is a sterling illustration of the old cliché that sometimes it's worse to miss by an inch than a mile. The provisions for handling large financial institution failures have progressed a great deal from last summer’s Obama administration proposal. They borrow a lot more from the bankruptcy laws, for instance. And there’s a lot of tough talk about ending too big to fail and harsh medicine for large financial institutions that stumble. But the framework has more than enough wiggle room for bank regulators to bail out creditors as they did in 2008, and it gives them a $50 billion pot of cash to do it with.  The end result is as bad, and could even be worse, than the original, for reasons described in more detail in this op-ed from a couple of days ago.

The bill also resolves the debate over whether to establish a Consumer Financial Protection Agency to police credit cards and mortgages in a strange way. The Dodd Bill does call for a new consumer watchdog—a good thing, in my book-- but would stick it in the Federal Reserve. The Fed focuses on protecting the banking system, which often benefits from credit card and mortgage terms that may hurt consumers. If the watchdog is sufficiently independent, the arrangement might work. But the proposal seems to invite lots of cognitive dissonance within the Fed.
If I were a lawmaker and were forced to vote today, the resolution provisions would put me squarely in the no category. But if I were a Republican lawmaker, the last thing I would do is commit myself to opposing any financial reform package that emerges from Congress. The politics of financial reform seem very different than the healthcare debate, as I’ve argued before, given the distaste for bailouts on both sides of the political spectrum. If the Dodd Bill were amended in ways that really made good on the claims to end too big to fail and to reduce the need for bailouts, it might be worth voting for. But we definitely aren’t there yet.


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Comments ( 5 )

Professor Skeel,

Isn't the problem not whether the government has the power to bail out creditor, but allowing these banks to get so leveraged that they are too big to fail? Even if Congress passes a law today that says that federal government will never again initiate a future AIG-style bail out of a financial institution in the future, does anyone really think that if faced with another AIG-situation, Congress and the President won't make the same decision again?

Isn't the solution to prevent institutions from getting to that point again? And it seems pretty clear that the market is not capable of doing it on its own. If they were, following LTCM or even Bear's bailout, they would have gotten their houses in order. But they did not and Lehman, AIG, Citi and BofA all essentially failed.

To prevent a future AIG or Citi, there needs to be strict capital requirements probably coupled with a size limit so that no one institution can bring down the entire system.

Professor Skeel,

Wasn't some of the problems that occurred after Lehman failed and filed bankruptcy that in Europe many of its clients assets were frozen (and still might be frozen). This forced them to sell other assets to raise cash in an already down market causing the market to fall further.

Banks are just different institutions than other companies that are forced to file for bankruptcy protection. Isn't continued access to one's deposits one of the primary reasons that the FDIC comes in over a weekend, takes over a failed bank and has it open again on Monday morning? If commercial banks or S&L were forced into bankruptcy without the FDIC, wouldn't depositors assets be frozen for a long period of time (possibly until the company either liquidated or reorganized)?

Hi, Matt-- The problems in Europe weren't related to ordinary deposits. My understanding is that many of the difficulties in getting assets back involved hedge funds that had used Lehman as their broker. In many cases, the problems were a function of the way the contracts were structured-- e.g., they gave Lehman the right to take the assets and use them as security in other transactions. In my view, in these transactions, the risk of the assets being frozen was a risk the parties took when they structured the transactions this way. As far as the FDIC's quick actions when it shuts down a bank, this does assure continuous access to deposits. One can debate whether the FDIC could itself provide continuous access to funds if it didn't shut down banks over the weekend, but the more important point in my view is that deposits are a very small portion of the liabilities of a large financial institution. Big institutions are a different creature than the small and medium sized banks the FDIC handles.

Professor Skeel,

Thanks for the response. I did not mean to suggest that the assets that were frozen in Europe were deposits. While I agree that the hedge fund customers took risks when they structured their agreements so that the brokers can pledge the assets in other transactions, isn't that similar to what depositors do when they deposit money with a bank: the bank does not keep the money in the vault; rather, it lends it out to other customers. Without FDIC insurance, those depositors take the same risk as prime brokerage clients. I am not proposing that the FDIC insure prime brokerage accounts, but I do not see how a $50bn fund with bailout the creditors of JPMChase or Goldman whose size is in the trillions.

As I have said in above comments, I think it is far better to limit the size of the banks and the amount of leverage they can have. Without those limits, we will end up with banks which are too big to fail. Anything too big to fail, should be too big to exist.

And is it normal for the Fed to come and fund a trading operation of a bankrupt broker-dealer? What would have happened if it the NY Fed had not funded Lehman's trading operation?

Professor Skeel,

I wanted to add one thing. While I have not read the Dodd bill, I have heard numerous people say that any financial firm that fails will go into receivership and current management and shareholders will be wiped out. But I am surprised to hear very little mention of giving creditors a hair cut or wiping some of them out. If creditors are not put at risk, another credit bubble will occur. I assume that is why you favor bankruptcy, because creditors will be at risk there.