|Did Dodd-Frank start from misconceptions? (April 7, 2011)|
Author argues lawmakers focused on the wrong issues
April 7, 2011
The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences. By David Skeel. Wiley, 2010, 220 pp. See an update regarding a related FDIC report on Lehmann Brothers at the end of this article.
Reviewed by Dr. Keith Leggett, senior economist in the Office of the Chief Economist at the American Bankers Association. Prior to joining ABA, Dr. Leggett was an Associate Professor of Economics at Davis & Elkins College. Dr. Leggett’s responsibilities at ABA include analyzing the structure and performance of the banking industry and monitoring conditions in the macroeconomy and in the credit markets. You can read about his credit union blog, and ABA’s economics blog, below, following his review.
David Skeel’s The New Financial Deal is a critical essay of the Dodd-Frank Act, the most sweeping financial legislation since the recovery from Great Depression. Critiquing the Dodd-Frank Act through the prism of bankruptcy, Skeel contends that the Act establishes a partnership between large banks and the government, enshrines ad hoc intervention in a crisis, and undermines the general rule-of-law principles.
Roots in the wrong soil
Skeel, a law professor at the University of Pennsylvania, believes that the development of Dodd-Frank was shaped by the wrong narrative about the financial crisis—the collapse of Lehman Brothers. The Lehman narrative takes the position that the firm’s bankruptcy was responsible for unleashing the financial crisis that froze capital markets and plunged the U.S. economy into its deepest recession since the Great Depression. The Lehman narrative concludes that bankruptcy is not adequate to handle the collapse of major financial institutions. Skeel contends that, had Bear Stearns been allowed to fail, instead of receiving an ad hoc rescue in March 2008, Lehman would have looked quite different.
According to Skeel, Dodd-Frank relies too heavily on regulatory discretion, as it singles out large financial institutions for special treatment, thereby creating a partnership between the government and these large financial institutions. This special treatment distorts markets, giving these large financial institutions a competitive advantage to borrow at rates significantly cheaper than smaller competitors. In return for the special treatment, policymakers are now able to advance their political agendas through these institutions, Skeel argues.
For example, the author points out that one of the centerpieces of the Dodd-Frank Act was the creation of the Financial Stability Oversight Council (FSOC), which is led by a regulatory body that has little independence under the executive branch. The Treasury Department, the least politically independent of the financial regulators, was made first among equals on the FSOC, and, in addition, Treasury runs the Office of Financial Research (OFR). Skeel writes: “[The] Dodd-Frank Act virtually ensures that the government will lean on the systemically important financial institutions, injecting political calculations into their business operations.”
Skeel also argues that Dodd-Frank will ultimately result in a system of ad hoc interventions by regulators, rather than providing a series of rules dictating when and how regulators must respond. The rule-of-law dictates that rules be transparent and knowable in advance. For example, while the Dodd-Frank resolution regime is targeted at Systemically Important Financial Institutions (SIFIs), the resolution rules do not require that the institution be declared significantly important in advance.
Moreover, the author believes that FDIC is ill-equipped to resolve larger financial institutions. In fact, he contends the resolution of a big bank will only result in a big bank becoming bigger, which will only exacerbate the problem of “too big to fail.” Additionally if no buyer is present for a large financial institution, the options will be limited to postponement, bailout, or both. Skeel expresses deep concerns that FDIC will be able to pick and choose which creditors to pay in full and which to leave with the dregs.
The author believes the two most important contributions from this legislation: (1) the framework of clearing derivatives and trading them on exchanges, and (2) the creation of the Consumer Financial Protection Bureau. (I do not share Skeel’s enthusiasm for the new consumer agency, nor do many bankers.)
Problems with Dodd-Frank’s financial remedies
Although Skeel writes that the clearing of derivatives set up by Dodd-Frank is an improvement, he does have concerns. He worries about how the market for clearinghouses will develop. If it is dominated by one or two clearinghouses (which he believes will be the likely outcome), then each will be a source of systemic risk. However, if there are many clearinghouses, these entities may face perverse incentives to lower their standards to attract business—akin to the problem with the credit rating agencies. Additionally, the development of clearinghouses will mean that parties in a derivative contract will not be concerned about one another’s finances, thus shifting the risk to the clearinghouse.
However, Skeel does not propose repealing Dodd Frank, but suggests that the rule-of-law be brought back into the picture. The author firmly believes that bankruptcy could come to the rescue of Dodd-Frank and suggests four reforms:
• Remove the special protections that derivatives and other financial innovations are given in bankruptcy. Skeel contends that if you reverse this special treatment, the resolution regime proposed by Dodd Frank would rarely, if ever, be used.
• Allow security brokerages to file for Chapter 11.
• Create a special pool of judges to handle the bankruptcy of a financial institution.
• Prevent government abuse of the bankruptcy process, as had been the case with Chrysler’s bankruptcy.
In conclusion, Skeel views that a major shortcoming of Dodd-Frank Act was the failure to tailor bankruptcy rules to address large distressed financial institutions. This arose in part from a belief that the bankruptcy code is ill-equipped to handle large financial entities. The author also posits that Dodd-Frank was a victim of political infighting as neither Representative Barney Frank nor Senator Dodd, then the heads of the House and Senate banking committees, wished to relinquish the reins of the reform process. Including bankruptcy as an option would have created jurisdictional issues as “bankruptcy legislation is the prerogative of the Judiciary Committee, while financial reform belongs to the Senate Banking and the House Financial Services Committees.”
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Update: FDIC releases Lehman Report
On April 18, 2011, FDIC released a report, The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act , today examining how the FDIC could have structured an orderly resolution of Lehman Brothers Holdings Inc. under the orderly liquidation authority of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) had that law been in effect in advance of Lehman's failure.
Lehman's bankruptcy filing on September 15, 2008, was a signal event of the financial crisis. The disorderly and costly nature of the bankruptcy-the largest financial bankruptcy in U.S. history-contributed to the massive financial disruption of late 2008. The lengthy bankruptcy proceeding has allocated resources elsewhere that could have otherwise been used to pay creditors. Through February 2011, more than $1.2 billion in fees have been charged by attorneys and other professionals principally for administration of the debtor's estate.
The FDIC report concludes that Title II of the Dodd-Frank Act could have been used to resolve Lehman by effectuating a rapid, orderly and transparent sale of the company's assets. This sale would have been completed through a competitive bidding process and likely would have incorporated either loss-sharing to encourage higher bids or a form of good firm-bad firm structure in which some troubled assets would be left in the receivership for later disposition. Both approaches would have achieved a seamless transfer and continuity of valuable operations under the powers provided in the Dodd-Frank Act to the benefit of market stability and improved recoveries for creditors. As required by the Dodd-Frank Act, there would be no exposure to taxpayers for losses from Lehman's failure.
The report will appear in a forthcoming issue of the FDIC Quarterly, scheduled for release in June.
[This article was posted on April 7, 2011, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2011 by the American Bankers Association.]
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