Dodd-Frank Increases Likelihood of Bailouts

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from NCPA,

The Dodd-Frank Act, the epitome of the post-2008 financial crisis regulation, has strengthened rather than ended the “too big to fail” doctrine, argues Norbert Michel, research fellow at the Heritage Foundation.

In short, the “too big to fail” doctrine espouses the notion that large, but failing, firms should be supported by government funds rather than being allowed to fall into bankruptcy, because of their size and significance within the economic landscape. The concept is what led to the federal government’s bailouts during the 2008 financial crisis of firms such as Bear Sterns and General Motors. The GAO estimates the Federal Reserve lent $16 trillion through its emergency programs between December 2007 and July 2010, $0.8 trillion less than 2013’s GDP.

What’s wrong with the concept of “too big to fail?” Michel deems it dangerous, explaining:

– It incentivizes risky behavior, because large firms believe they can count on the government to bail them out in times of trouble. Because costs are “socialized” and spread among taxpayers, managers are more likely to take on risk.
– Government officials are allowed to decide which firms are bailed out and which ones must survive on their own. This is a problem because the least efficient and most troubled firms are the ones most likely to fail — saving them promotes less efficient economic activity.

The Dodd-Frank Act was passed in response to the financial crisis, with the idea that greater regulation would keep financial markets more stable. As Michel explains, the act established the Financial Stability Oversight Council (FSOC). The role of FSOC? To monitor the U.S. financial industry and identify which firms’ failure would cause problems for the American economy. Firms that it deems “systemically important” (in short, “too big to fail”) are hit with even more expansive regulations, and the council has a wide range of regulatory authority. On top of that, under Title II of the law, Dodd-Frank even authorizes the FDIC to seize struggling firms and close them down.

Michel argues that such extensive regulation will do nothing to make markets more secure. He offers a few suggestions for Congress, including:

– Repeal Dodd-Frank entirely. The law “expanded the federal safety net for financial firms,” says Michel, only making future crises — and subsequent bailouts — more likely.
– Use bankruptcy law for large institutional failures, not Title II, and allow them to wind down their affairs like any other company through the typical bankruptcy process.
– Don’t allow the Fed to make emergency loans to private firms.
– Eliminate the Financial Stability Oversight Council, which Michel calls “wholly incompatible with the functioning of a dynamic private capital market.”

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