Something that I think hasn’t gotten the attention it deserves is that whatever doubts you may have about prudential regulation in Chris Dodd’s bank regulation bill it (and the House bill too) takes apart the too big too fail very nicely:
Resolution authority is key. The reason that TBTF works is because bankers count on bailouts from the government. The industry knows the choice for regulators has basically been between bailouts or a messy bankruptcy. What Dodd’s legislation does, however, is restrict the ability of regulators to bailout insolvent banks; for instance, the Fed can no longer make loans to specific firms. But regulators’ ability to liquidate insolvent companies has been enhanced, and given greater incentive thanks to a $50 billion fund to ease the costs of liquidation. This mechanism adds great credibility to the government’s attempts to remove the implicit bailout guarantee and reassert market discipline, and makes it harder for regulators to funnel money into the banks during an emergency.
As a sidebar, let me note that virtually every aspect of the phrase “too big to fail” is misleading. The issue is that when a firm doesn’t have enough money to pay its creditors what it owes, it files for bankruptcy. What happens when a firm fires for bankruptcy is that the firm’s obligation to pay off its debts is temporarily lifted and the debts themselves are typically restructured so that the firm doesn’t wind up paying everything it owes. This is a problem when the firm is in the business of borrowing short to lend long—in other words, when the firm is a bank. It’s a problem because if PNC Bank were to declare bankruptcy we would find that its creditors are the people (like me) who have deposits at the bank. If nobody with a deposit at PNC could access our accounts, we’d all have a big problem. And other people looking at our problems might suddenly start withdrawing their deposits from other banks, causing problems to spread. Now it’s true that the bigger than bankrupt bank, the bigger the problem, but the problem isn’t caused by bigness, it’s intrinsic to the idea of banking. A small bank going bankrupt is just a small problem.
This is why we have the FDIC. It doesn’t prevent banks from failing. But it establishes a mechanism other than bankruptcy for dealing with a bank failure. The problem is that as finance has developed, many institutions (the “shadow banking system”) have emerged that borrow short and lend long but aren’t covered by the existing FDIC resolution mechanism. That means that in order to prevent shadow bank runs (as occurred when Lehman Brothers went under), the government has resorted to “bailouts.”
The idea of “resolution authority,” which sounds boring, is to stop the bailouts without wrecking the economy. It’s to say, in advance, “okay, we recognize that there’s a whole class of institutions that we don’t want to see ever go into Chapter 11 bankruptcy and we’re going to write down in advance what should happen when they become insolvent.” And since dealing with an insolvent firm without bankruptcy isn’t going to be free, we set up a mechanism to raise the funds necessary from the institutions who are being given this protection from bankruptcy. In my view, it’s the single most important piece of the puzzle, and also the one on which Dodd’s bill is the least compromised.