In defense of Dodd

The Republican attack on the Senate financial reform bill is unfounded

Though byzantine on paper, at its heart, the Senate financial reform bill of Chris Dodd’s (D-CT) is sweet and simple. We will expand the resolution authority of the Federal Deposit Insurance Corporation so that it will be able to do more than simply place small-to-mid-sized banks in federal receivership.

Under this bill, if the financial regulator decides a financial institution is insolvent, that bank would effectively be taken over, chopped up, and sold off. By granting the FDIC new capabilities, previously untouchable financial institutions — those that do not currently fall within the FDIC’s strictly defined regulatory purview, are large enough such that their resolution would require the FDIC to hold on to and manage their assets for a period longer than they are equipped to handle, or perform systemically important functions (like transaction clearing) that the FDIC is not equipped to duplicate during the resolution process — would now be allowed to fail.

In addition, this bill would improve regulatory oversight across the financial sector, creating smarter capital requirements and improving the information that feeds regulator decisions. Not only does this bill give us the much needed ability to “fail” a bank, but it also makes it much more likely that we will correctly decide when to fail a bank.

There is deep and fertile ground for debate on financial reform. Which classes of depositors should the FDIC extend deposit insurance to? Should financial institutions be allowed to place classes of depositors that we do not wish to insure, such a proprietary traders, under the same roof as those we do wish to insure, such as retail bank customers? How should we implement risk-based capital requirements such that they intelligently reduce the risk of socializing losses, but remain resistant to gaming of the system and avoid creating sources of correlated risk across institutions (as happened when credit rating agencies mis-assessed the risk of subprime mortgages).

How should we strike the balance between failures to detect (not failing an insolvent bank, leading to a bailout) and false alarms (failing banks that are not insolvent)? How should we strike the balance between reducing the compliance costs of regulation versus improving the decision-making accuracy of the regulator? How can we design organizational incentives such that the regulator strikes the balance between these Type I and Type II errors in the same way that society wishes it to strike the balance? Given the difficulty in aligning the regulator’s incentives with those of society and the tendency of hard rules to be circumvented by private actors, how much should we leave the process of oversight to regulator discretion versus inflexible rules? How do we harmonize the resolution process for international firms, where there is a tension during the resolution process between paying off domestic depositors before foreign depositors? Should complex financial constructs, such as some classes of derivatives, be banned on the grounds that regulators and credit rating agencies lack the sophistication to value them? Can we mitigate the systemic effects of counter-party risk by bringing derivatives into a clearinghouse structure, without sacrificing the value that derivative customization might provide? These are not simple questions, even for technical experts, and require the sort of tough value judgments that inevitably generate controversy.

However, instead of delving into these weighty problems, Republicans have seized upon two provisions in the bill — the so-called “bailout fund,” a $50 billion ($150 billion in the House version) pot of money raised through a tax on financial institutions, and the decision to identify systematically important firms and require them to create resolution plans — and by misconstruing these provisions, are now trying to turn what should be a technical, non-partisan debate about how best to accomplish mutually held goals, into a partisan point-scoring opportunity.

Perhaps, in part, the GOP can be forgiven. After all, it’s not as if Democrats haven’t been trying to score points throughout this process as well, and surely a loyal opposition is entitled to strip away the spin that the majority has applied to their favored policies. We should recognize the “pre-funded resolution fund” for what it is: a pre-paid bailout tax whose costs will be passed on to bank customers (not absorbed entirely by a fall in bank profits, as Democrats pretend). We should also be concerned that identifying systemically important institutions will remove the constructive ambiguity that might otherwise keep “heads-I-win-tails-you-lose” financial gaming in check.

On the larger point however, Republicans are engaging in pure political deception. We should not for a moment give credit to the charge that the Dodd bill creates “bailouts forever.” Preparing for a rainy day is not the same as causing a rainy day. As much as we might wish to completely eliminate any chance of future socialized losses, we have to accept that regulators do not operate with perfect information, and even with best intentions will inevitably make mistakes. The loss of constructive ambiguity that comes from not making it clear whether the government will offer bailouts is more than offset by the improved resolution authority that this bill creates. If anything, the bill as it stands does not do enough to promote bailouts. If a regulator incorrectly decides a bank is insolvent, and forces them into receivership, there is no way to second-guess their assessment. We have no counter-factual with which to compare — because we never got to see the future play out, it is only the bank’s word against the regulator’s that a bailout would have otherwise happened. But if a regulator fails to stop an insolvent bank from making bets on the taxpayer’s dime, it will be patently clear that they made a mistake. In hindsight, we would be able to say something to the effect of, “You should have dissolved this bank two months ago.” The organizational incentives faced by the regulator are such that we should expect them to be trigger-happy when it comes to closing banks, not the other way around.

The Republican claim that this reform bill is being rushed is correct. There is no hurry, and the public deserves a full and honest debate on how we will regulate our financial markets. But there are two sides of this coin — before Democrats slow the pace, Republicans need to prove themselves capable of honest argument.