Friday, February 25, 2011

Davidoff on TBTF

Steven Davidoff (a.k.a. "The Deal Professor" on Dealbook) is one of my favorite commentators, but I thought his recent piece on "systemically important" financial institutions was an unusually poor effort.

He starts the article with a rather brazen assertion:

The Dodd-Frank Act deliberately did not end the era of too-big-to-fail institutions. ... Dodd-Frank instead set up a structure that would let the behemoths live, but they would be caged with a monitoring approach. Too-big-to-fail institutions are to be named and subject to extra regulation.
Well, did Dodd-Frank end "too big to fail"? That's a very complicated question, and one which no serious commentator can answer with any degree of certainty right now. If large financial institutions can be successfully resolved under the new resolution authority, then the era of TBTF will indeed have ended, so any serious discussion of whether Dodd-Frank ended TBTF would have to include a detailed analysis of the resolution authority (something which I've started to do here and here). And, of course, whether the resolution authority will work depends critically on, among other things, the new "prompt corrective action" regime for large financial institutions (DFA § 166), which the Fed and FDIC haven't even begun to devise yet. So anyone who simply asserts that Dodd-Frank "did not end" TBTF fundamentally doesn't understand the Dodd-Frank Act. At the very least, it's absolutely untrue that Dodd-Frank deliberately didn't end TBTF.

Davidoff then goes on to discuss the consequences of being labeled a "systemically important" financial institution:
Too-big-to-fail banks may receive important competitive advantages from a lower cost of capital. Their cost to borrow money will be lower because they are perceived to receive an implicit government guarantee. They can also command greater access to regulators. And there are probably positive psychic effects of being labeled a big dog in the world financial economy. It may even secure the executives of these financial firms a coveted invitation to the yearly party at the World Economic Forum in Davos, Switzerland.
When people say that institutions labeled "systemically important" under Dodd-Frank are being labeled "too big to fail," it kills me. It's one of my pet peeves, you could say, because: (a) like I said before, it betrays a serious misunderstanding of Dodd-Frank; (b) it's most likely not true; and (c) to the limited extent that it may be true, you're only making it worse by casually claiming that these institutions are being deemed "too big to fail"!

Honestly, the idea that being labeled "systemically important" under Title I of Dodd-Frank gives an institution an "implicit government guarantee" is ridiculous. For one thing, these are the institutions that will be subject to the new resolution authority — something that will make it easier for an institution to fail. Also, where is this government guarantee supposed to come from? Not the Fed: Dodd-Frank stripped the Fed of its "Section 13(3) authority" to bail out individual institutions. Not the Treasury: it never had the statutory authority to bail out individual financial institutions. Not the FDIC: "open bank assistance" is prohibited under the new resolution authority. The only option would be for Congress to pass emergency legislation bailing out a faltering institution, which is something I think is highly unlikely, especially in the next several years, given how politically toxic "bailouts" have become. (Remember, even the much-loathed TARP wasn't a bailout of an individual institution, or a select group of large institutions; it was broadly applicable to all "financial institutions.")

And if being labeled "systemically important" really did come with an implicit government guarantee, then do you really think we'd see every single major financial institution arguing vociferously that they should not be labeled "systemically important"? I imagine Davidoff would counter that this just shows that the costs of the heightened regulation that comes with the "systemically important" label outweigh the benefits of an implicit government guarantee — but if that's the case, then Dodd-Frank is successfully discouraging financial institutions from becoming "systemically important," thus showing yet again that Dodd-Frank didn't "deliberately" fail to end TBTF.

Now, you could argue that the markets, whether they're right or not, will still perceive an implicit government guarantee for these institutions. First of all, I think that's wrong — the heightened regulatory regime that "systemically important" institutions are subject to will also reinforce that these institutions are eligible for the new resolution authority. Second, even if the markets (or the rating agencies) do perceive an implicit government guarantee for these institutions, that doesn't make them right. It may incrementally lower "systemically important" institutions' costs of funds in good times, but it doesn't obligate the government to bail these institutions out, which is what really matters in this debate.


(Despite my criticisms of this particular article, I do urge you to read Davidoff's "Deal Professor" articles on Dealbook, which are generally excellent. I also highly recommend his recent book, Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion, which was easily one of the best financial crisis books.)


Main Street Muse said...

EoC - Dodd-Frank may not have "deliberately" ended TBTF, but let's face it, it did not end TBTF.

Even you, who I view as someone who knows his way around Wall Street, say, in reference to the question of whether Dodd-Frank ended TBTF: "that's a very complicated question, and one which no serious commentator can answer with any degree of certainty right now."

Since there is "no degree of certainty right now" if we can truly resolve "systemically important institutions" without a rerun of TARP, et al, TBTF has not ended, at least not officially. The dream is there, yes, and it's a dream that hopefully will never die, but the practical solution of how to shut down "systemically important" banks has not been fully developed.

[And to me, "systemically important" really, truly, sincerely seems like code for TBTF - don't know how you can parse it any other way. It's like "pre-owned" being used instead of "used cars." Same product, but now with kinder, gentler name.]

Since, as you note, details have not yet emerged on how to unwind "systemically important" banks in ways that don't include a massive federal bailout, it is unclear how you can assert that the government will no longer bailout institutions deemed "systemically important."

And until specific plans are in place, the financial sector will mostly likely continue to operate on the bailout principle...

David Pearson said...


Does Dodd-Frank prevent the Fed from guaranteeing large swathes of financial institution liabilities? If not, then TBTF is still TBTF.

The fact is Dodd-Frank envisions a single entity failing without affecting the system. It does a poor job of addressing systemic risk, where the Fed cannot allow single-entity bondholders to suffer losses without infecting, and collapsing, the entire system. Believe me, the Fed will do everything in its power to save that first "domino". Guarantee all ABCP? Check. Guarantee all AAA-rated repo collateral? Check Check. Offer to swap Treasuries for all AAA-rated bonds on TBTF instution's books? Triple check.

The ECB is prevented by law from bailing out single countries. That doesn't stop it from vacuuming up PIIGS debt under the guise of, "maintaining orderly markets," and "ensuring ample banking system liquidity." You think the Fed wouldn't do the same under Dodd-Frank?

You might argue that the above doesn't consitute a "bail out". I would respond that, from a TBTF bondholer's perspective, the Fed has their back, Dodd-Frank or no Dodd-Frank.

David Pearson said...

BTW, looking back at your Dodd-Frank posts, one thing stands out: you argue that an effective path to orderly liquidation and bondholder haircuts is laid out by the legislation. This ignores the question: during a financial crisis, what will other institutions' bondholders do if they see haircuts being doled out? Dump their bonds, sending a cascade of asset sales and illiquidity through a fragile system.

Apparently, the clear lesson of 2008 for policy makers was, "during a systemic crisis, defend bondholders at all costs." I don't agree with it, but there it is.

Economics of Contempt said...

David Pearson,

I think it's pretty unlikely that the Fed will institute a system-wide bailout to save a single institution. You can disagree, but I don't think you can use Fed's actions in 2008 as a proper precedent, because they didn't have the option of resolving BHCs outside of bankruptcy in 2008, which they will now have. Also, it's not clear that many of the Fed's emergency lending facilities from 2008 would pass muster under the Fed's revised Dodd-Frank authorities.

I think if they were going to do something like a system-wide bailout, the more likely scenario would involve letting the faltering institution fail, and then extending broad-based emergency lending facilities to everyone else. But again, even that's unlikely, in my opinion.

I think that when it comes down to it, they'll realize that an FDIC-like resolution just isn't as scary as people think it is. (They'll probably realize that far in advance, actually.) Will it require bondholder haircuts? Probably. But it likely won't require massive, system-shaking bondholder haircuts.

Anonymous said...

It should be obvious that TBTF is still there. It will depend on who's the Sec of the Treas and how bad he/she thinks things are going to get. If the "first domino" is really big--say BofA, it's not going down. What may happen is an FDIC type wind-down for smaller less politically influential firms, instead of a "dollar a share" sale to another TBTF firm. The Govt is not going to liquidate any significant number of TBTF firms over a short period of time--that would be scary. What this does is make the line between TBTF and not-TBTF very fuzzy.

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