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What if Dodd-Frank is Built on Faulty Assumptions?

In the aftermath of the 2008 financial crisis, the phrase “too big to fail” (TBTF) became firmly ingrained in the American public conversation about financial regulation. TBTF describes financial institutions so central to the financial system that, if the firm approaches bankruptcy, the government may provide it some sort of bailout to stave off systemic economic collapse. The enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act embedded the concept of TBTF into law. Indeed, the preamble to the Dodd-Frank Act explicitly highlights an effort to end TBTF.

Yet the TBTF paradigm may be showing cracks. In a recent paper entitled “Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility,” a Duke University School of Law professor, Steven Schwarcz, pushes back against this dominant TBTF rhetoric. Although Schwarcz empathizes with the interest in reducing taxpayer responsibility in the event of a bank failure, he does not view TBTF rhetoric favorably.

Cityscape of Manhattan Financial DistrictTo Schwarcz, TBTF is based on a fundamental misunderstanding of what causes excessive risk-taking at banks. Instead of bankers counting on bailouts to solve their hazardous behavior, Schwarcz believes bankers engage in risky behavior because they do not correctly evaluate risks to the firm versus risks to the public at large. To remedy excessive and dangerous risk-taking, Schwarcz proposes creating a new corporate governance duty and a privately-funded bank bailout fund.

Schwarcz presents two approaches to his proposed public governance duty for firm directors and managers. One approach would be for a firm’s managers to weigh the possible risk to the public just as they would in any normal firm decision. The other approach would require directors to objectively weigh the expected values to the firm and to society against each other. Schwarcz suggests the government could provide a value for systemic costs of the firm’s failure to any cost-benefit calculation, though he does not provide any color on how the government would determine such a number. Managers would then receive protection from personal liability for good faith decisions made without conflicts of interest.

Schwarcz also suggests reforming financial regulation to minimize bailout costs on the public by taxing important firms to create a private bailout fund. Several existing programs could serve as a model, including a nuclear insurance and disaster relief fund, which requires private businesses to pay into funds to share possible losses.

Schwarcz does name two major risks to such a fund: regulators probably lack sufficient expertise to precisely determine the necessary size of the fund, and a greater degree of international cooperation is necessary; otherwise, firms will flee the high-tax United States for lower-tax jurisdictions.

Schwarcz finds no evidence to show that moral hazard created by TBTF—that is, bankers taking excessive risks because they know they can count on a taxpayer bailout—causes banks to change their behavior. As Schwarcz notes, large firms being able to borrow with lower interest rates is the only empirical evidence of moral hazard, but it is not clear that rates are actually lower because of the likelihood of a bailout. Schwarcz points to a number of other reasons that a large bank might be able to borrow at a low cost, including economies of scale. Further, Schwarcz believes the individual professional consequences—namely, being fired—felt by managers after a bailout discourages excessive risk-taking.

If moral hazard does not cause excessive risk-taking, then what does? Schwarcz argues that managers of firms evaluate the risk of a given action differently for the firm and for society at large. An action can have a positive expected return for a firm’s shareholders, but a negative return for society at large. This is possible because the systemic harm caused by a firm failing would be spread across the broader economy, while almost all positive returns would be concentrated in the firm. In other words, any profits a bank earns will only be held by the bank or returned to shareholders, while the consequences of a firm failing will be felt by the financial system as a whole.

Our current scheme of misguided financial regulations results from this focus on moral hazard, Schwarcz argues. Regulation starting from an incorrect premise is “unlikely to control…risk-taking and could even be harmful,” he writes. Schwarcz identifies four approaches to regulating large financial institutions: limiting the size of firms, forcing firms to hold more capital, converting debt to equity in the event of a crisis, and controlling the failure of firms. However, he deems all of these approaches insufficiently effective and possibly dangerous.

Reducing the size of large financial firms would only cut the number of firms that could engage in risky behavior, not the propensity of those firms to do so, Schwarcz writes. As a bulwark against future losses, firms are required to hold a certain amount of reserved assets known as capital. However, if inappropriately applied, capital requirements could hamstring the economy by forcing firms to hold capital that would be of more use if it were invested, or vice versa. Converting debt to equity in the case of a crisis, an approach that has yet to be tried in the United States, can create perverse incentives for bankers to engage in riskier behavior; Schwarcz points out that bankers will know that the debt to equity conversion provides a floor on losses, an argument that seems to incorporate at least some of the TBTF logic.

Finally, Schwarcz notes two flaws inherent in attempting to control the failure of a firm. First, anecdotally drawing on his experience as a bankruptcy lawyer, Schwarcz expresses doubt that any firm’s failure—especially during a systemic collapse—can accurately be predicted. Second, Schwarcz argues controlling a firm’s failure by allowing federal insurers to take charge of the firm and then subsequently sell it to more permanent equity investors is impractical. On the other hand, George Washington University Law School professor Arthur Wilmarth has argued that this single point of entry strategy would not cause fewer bailouts.

Schwarcz concludes the paper by noting that TBTF regulation likely will succeed only in limiting the number of government bailouts, not eliminating them. As a result, it is important that his proposals—which would similarly be targeted at limiting the number of required bailouts—provide solutions to reduce taxpayer cost in the event of a bailout.

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