Writing in (the always excellent) City Journal, Washington lawyer Adam White reviews the recent books by former Federal Reserve chief Alan Greenspan (The Map and the Territory) and former Treasury secretary Tim Geithner (Stress Test), the latter of whom served as boss of the powerful New York Fed during the height of the 2008 financial crisis. White’s whole piece is worth reading, but one section is particularly notable: the section in which he discusses “too big to fail” (TBTF).
Six years after President Bush signed into law the Troubled Asset Relief Program (a.k.a. “the bank bailout”), and more than four years after President Obama signed into law the Dodd-Frank Act, is TBTF a thing of the past? If only. Speaking at an Institute of International Finance conference on October 11, Fed governor Daniel Tarullo acknowledged that TBTF lives on.
In fact, many analysts argue that Dodd-Frank reinforced TBTF, in part by designating a select group of mega-banks as “systemically important financial institutions,” or SIFIs, and authorizing federal regulators to give non-bank financial firms — such as AIG, Prudential Financial, and MetLife — the same designation. America’s largest banks have long enjoyed a funding advantage (i.e., reduced borrowing costs), and the concern is that Dodd-Frank will solidify and/or increase this advantage, while also conferring it on various non-banks. On the other hand, defenders of the 2010 law point out that SIFIs face much tougher regulations than non-SIFIs.
Thus, as American Enterprise Institute scholar Peter Wallison has written, receiving the SIFI tag could be either a net positive or a net negative for a given company, depending on whether the funding benefits outweigh the regulatory costs: “Either we will have large, successful, government-backed firms that swallow up smaller competitors, or we will have large, unprofitable, heavily regulated giants that are gradually driven to failure by their more nimble and less regulated competitors. In the former case, small firms are the victims. In the latter case, taxpayers will pay for the bailouts.”
In his piece on the Greenspan and Geithner books, White compares their respective views of TBTF and Dodd-Frank:
“By and large, Greenspan sees Dodd-Frank not as solving too big to fail but exacerbating it. By designating banks and nonbanks as ‘SIFIs,’ regulators are officially ‘rendering them guaranteed by the federal government,’ just as Fannie Mae and Freddie Mac were. Investors, in turn, ‘will continue to underprice the risk-taking of these financial institutions, overfund them, and fail to provide effective market discipline’ — thus only encouraging the institutions to ‘take on too much risk.’ While Greenspan doesn’t directly discuss Dodd-Frank’s ‘Orderly Liquidation’ process, he does offer his own substantially different framework for how best to allow SIFIs to fail: instead of granting the Treasury and the FDIC effectively unbounded power with minimal judicial oversight (as Dodd-Frank does), Greenspan would turn first to private financing and then, if necessary, would break up the financial institution into smaller units in a process managed by federal judges.
“Geithner criticizes Dodd-Frank, too — but from precisely the opposite direction. He argues that Dodd-Frank gives the Fed and the Treasury too little discretion, not too much. He likes the SIFI-designation process but complains that it should be handled by the Fed, not by the interagency Financial Stability Oversight Council. More significantly, he approves of the ‘Orderly Liquidation Authority’ but regrets that Congress combined it with a new limit on the Fed’s power to bail out individual companies. The Fed’s primary tool in the crisis, he explains, was Section 13(3) of the Federal Reserve Act, which empowered the Fed, in ‘unusual and exigent circumstances,’ to lend directly to borrowers unable to obtain credit elsewhere. Dodd-Frank nominally pares back this power, by requiring that such lending be directed not to individual firms, but rather with ‘broad-based eligibility,’ to prevent regulators from bailing out individual, politically favored banks. According to Geithner, this limit on Fed discretion, coupled with other limits on the FDIC’s power to backstop banks, ‘will hinder the response to the next crisis.’
“Geithner’s criticism of these statutory limits is less surprising than his earnest suggestion that the statutes actually limit anything. Throughout the crisis, Geithner and his colleagues consciously pushed their authority as far as possible — if not by exceeding statutory limits on their powers (which he argues they never did) then by interpreting those statutes as generously as possible. We can trust his successors to interpret Dodd-Frank’s new ‘restrictions’ with similar creativity, especially when a variety of commentators (including Richmond Federal Reserve Bank president Jeffrey Lacker, Harvard Law School financial systems professor Hal Scott, and House Financial Services Committee chairman Jeb Hensarling) argue that the amendment leaves more than enough room for the Fed to bail out specific firms.
“There are more substantive problems with Geithner’s policy prescriptions. He does not answer the objection, raised by Greenspan and others, that the Financial Stability Oversight Council’s formal ‘SIFI’ designations effectively provide concrete too-big-to-fail status. Geithner surely recognizes the seriousness of this issue. When FDIC chairwoman Sheila Bair attempted, during the crisis, to limit the class of troubled banks that would receive full government protection, Geithner argued that this sort of line-drawing would have perverse effects: ‘Once a government sets a dividing line between what’s guaranteed and what isn’t, it can spark a run from the debts and firms just beyond the line to the debts and firms on the safe side.’ Yet in endorsing Dodd-Frank’s new system of formal ‘SIFI’ designations, Geithner does not seriously grapple with the idea that the new SIFI ‘dividing line’ will spark the very same type of run.
“But the most troubling aspect of Geithner’s preferred framework is the corrosive effect that it has on the rule of law and our cultural preference for subjecting executive authority to it — a preference that undergirds our market system. Geithner himself acknowledges this, if only in justifying the administration’s refusal to prevent AIG from paying substantial bonuses to its employees after the government bailout. ‘We weren’t Venezuela,’ he writes. ‘In a storm, the world needs anchors,’ and the ‘rule of law was arguably our most important anchor.’ Yet at every turn — through the crises, and in the construction of Dodd-Frank — Geithner prefers discretion over statutory limits. And even setting aside the Fed’s ‘exigent circumstances’ power, the powers conferred upon regulators by Dodd-Frank’s ‘Orderly Liquidation’ provision — allowing the government to suspend fundamental bankruptcy-code rights and setting draconian limits on judicial review of the liquidation process — threaten the rule of law far more profoundly than limiting the AIG bonuses ever would have done.”