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At last, some consensus on Dodd-Frank

by William McConnell in Washington | Published May 16, 2013 at 9:24 AM

In Washington these days, the major players don't agree often -- and when they do it's only in the most narrow sense.

That's the case with the core provision of the Dodd-Frank financial reform law, the legislation enacted in 2010 to make sure that the government never again has to bail out major financial institutions when they fail.

Now, there appears to be recognition among both those who opposed and those who supported the law that it doesn't quite live up to that billing and that federal financial regulators still have discretion to use enormous amounts of government money to shore up large financial institutions if their failure threatens the economy.

On Wednesday, House lawmakers got an earful from bankruptcy and risk management experts about how to fix Dodd-Frank's shortcomings during a hearing held by the House Financial Services Oversight and Investigations Subcommittee. The lawmakers were given two choices: either force the biggest financial firms to break up or greatly limit, if not do away with, regulators' option of funding and restructuring a failing institution outside of bankruptcy.

That all sides acknowledge this is a victory of sorts for the majority of Republicans who opposed the Dodd-Frank Act when it was passed three summers ago.

"Dodd-Frank did not end too-big-to-fail but instead enshrined it," said Rep. Patrick McHenry, R-N.C., the subcommittee chairman.

McHenry noted that Federal Reserve Board Chairman Ben Bernanke, an architect of the law, admitted the shortcomings in a speech last week. McHenry also pointed out that U.S. Attorney General Eric Holder has worried publicly whether the law's perpetuation of institutions that cannot be permitted to fail without great harm to the financial system hamstrings the government's ability to prosecute large institutions and their executives for financial crimes.

California Democrat Brad Sherman, a member of the House Subcommittee, agreed that the shortcomings must be addressed, preferably by shrinking the biggest institutions and reducing their risk to the financial system. "We ought to break up those that are too big to fail and ... too big to jail," he said. "No institution should be so large that its creditors believe they will be bailed out and its executives believe they are immune from the laws."

Under the law, failing financial firms must be subjected to bankruptcy unless the federal regulators decide the institutions are so complex that they cannot be wound down within bankruptcy. At that point the Federal Deposit Insurance Corp. and the U.S. Treasury Department would have discretion to invoke their orderly liquidation authority, or OLA, to resolve the crisis. Under the OLA process the regulators must create a bridge company for the institution's continuing operations. Its shareholders and long-term bondholders would be wiped out, but many short-term creditors could have their claims transferred to the bridge company. Exactly which short-term creditors' assets are moved to the bridge company is entirely up to the regulators.

McHenry said this process allows the regulators to create new companies with huge competitive advantages, including lower borrowing costs and exemption from taxes, and to retain existing management if they choose.

Even Democrats now acknowledge the risks posed by law, but many of them insist the best way for them to be addressed is in an upcoming FDIC policy that will spell out specifics of implementing the OLA.

That's not good enough for David Skeel, professor of corporate law and the University of Pennsylvania Law School, who told lawmakers that despite the Dodd-Frank law's stated aim of putting failed financial giants out of business, the size of too-big-to-fail institutions and the subsidy they receive actually ensures that their "dominant position in finance has been retained."

Skeel called on Congress to eliminate regulators' power to exempt bailed-out firms from taxes on the value of their franchise, property and income. "There is simply no justification for this special treatment," he said.

Skeel also called on Congress to force the largest financial firms into bankruptcy if they fail.

John Taylor, professor of economics at Stanford University, agreed. He predicted regulators would nearly always opt to fund and reorganize companies rather than submit them to bankruptcy and to treat creditors in very disparate ways. "There is every incentive for the FDIC to provide additional funds so some creditors get above what they would get in a normal bankruptcy. This by definition is a bailout," he said. "It doesn't matter if the money comes directly from taxpayers or a tax on banks or from other creditors. It lowers interest rates [for the big institutions] and the moral hazards still exist."

Joshua Rosner, managing director at Graham Fisher & Co., opposes the bankruptcy option and said forcing the institutions to get smaller is really the only viable option, because they are too big to manage in a bankruptcy. "The market can't fund them in bankruptcy," he said, noting that the largest firms could need as much as $100 billion, which would strain even the Treasury's ability to access the needed cash.

The knowledge that the firms could not be pushed into bankruptcy would give them a perpetual marketplace advantage and encourage risky behavior, he said. "Why would creditors do business with companies facing normal threats when they can deal with one that is told it can never fail?"

Leaving the institutions at their present size, "leaves no cost to failure and allows no clear [bankruptcy] process for moving assets from weak hands to strong hands," Rosner said.

Alone in support of the law among those testifying (but backed by many Democratic lawmakers) was former FDIC general counsel Michael Krimminger, now a partner at Cleary Gottlieb Steen & Hamilton LLP, who said the agency's upcoming policy explaining how it would implement the OLA will address many of the shortcomings the Dodd-Frank Act's critics have identified.

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