Economist: Dodd-Frank Has Created a ‘Path of Least Resistance’ for Bank Bailouts

WASHINGTON – A group of top economists said a law intended to prevent future bailouts for big banks has only institutionalized the practice, while failing to address the problems that led to the financial crisis of 2008.

The 2010 Dodd-Frank legislation mandated hundreds of major regulations to control risky financial activities, with the aim of preventing a repeat of the taxpayer bailouts of “too big to fail” financial institutions.

Many experts have concluded that Dodd-Frank has worsened the too-big-to-fail problem by expanding capital requirements that contributed to the 2008 financial crisis by allowing banks to use arbitrary measures of risk, leading them to hold capital that did not have the same loss-absorbing capacity as equity. Since the late 1980s, federal regulators have required banks to hold a certain amount of capital (such as equity) based on the amount of money they lend to customers and the securities they hold (the bank’s assets). These rules are intended to force banks to build a cushion against unexpected losses.

Charles Calomiris, an economics professor at Columbia University’s Graduate School of Business, said Dodd-Frank has established an “explicit process” for bailing out a too-big-to-fail institution.

“Unfortunately, Title II of Dodd-Frank institutionalized the bailouts of too-big-to-fail banks rather than avoiding them. It did that because it creates a political path of least resistance for politicians to bail out the large banks,” Calomiris said at a panel hosted by the Heritage Foundation. “In fact, it not only creates the actual process through which that would happen, but even funds it through a special new tax.”

Dodd-Frank’s Title II gives the Treasury Department and the Federal Deposit Insurance Corp. (FDIC) the authority to “liquidate” financial companies. The financial reform law permits bailouts through the law’s resolution authority provision. This bailout would be financed by taxes on surviving banks, and if these funds are insufficient, then by taxpayer money.

To ensure resiliency in the financial system, Dodd-Frank regulations should be replaced by measures requiring large banks to increase their capacity to deal with losses, Calomiris said. This could be done by substantially raising the minimum ratio of the book value of their equity relative to the book value of their assets. In other words, require banks to increase their capital reserves.

In addition to higher equity requirements, Calomiris said requiring banks to issue contingent convertible bonds – a form of debt that would convert to equity if the market value of this debt relative to assets drops to a certain minimum – could impose market discipline on banks and, in the event of a financial crisis, allow them to raise new capital quickly.

Dodd-Frank created the Financial Stability Oversight Council (FSOC) to oversee and identify risks in the financial system. If FSOC finds that financial institutions create “systemic risks” and threaten financial stability, it can designate these firms systemically important and require them to satisfy enhanced capital, leverage, liquidity, and supervision requirements similar to those that Dodd-Frank prescribes for large banking institutions.