Today the House Financial Services Subcommittee on Oversight and Investigations held a hearing on whether the Orderly Liquidation Authority (OLA) in Title II of the Dodd Frank Act has reduced the likelihood of bailouts of large financial firms. I was one of the witnesses. Here is a summary of my 5 minute opening statement. More details are in my written statement.
Unfortunately the likelihood of bailouts has not been reduced by Dodd-Frank. Empirical evidence shows this: large financial firms still pay less to borrow because of market expectations of bailouts. Of course there’s disagreement about this assessment. Ben Bernanke argued in testimony in February that “Those expectations are incorrect” because we have Title II. But other officials differ: President Charles Plosser of the Philadelphia Fed says “Title II resolution is likely to be biased toward bailouts,” and President Jeffrey Lacker of the Richmond Fed admits “we didn’t end too big to fail.”
When you look at OLA and assess what would happen in another crisis you can see why bailouts are still likely. To carry out the difficult task of reorganizing a large financial firm under OLA, the FDIC would have to exercise a great deal of discretion which causes unpredictability and uncertainty compared with bankruptcy reorganization. Thus, there’s confusion about the reorganization process. Without more clarity, policymakers are likely to ignore it in the heat of a crisis and again resort to massive bailouts.
Even if Title II were used, bailouts would be expected. The FDIC would most likely give some creditors more funds than under bankruptcy law. By definition that’s a bailout of the favored creditors. Even if shareholders are not protected, some important creditors are.
It is important to recognize that the perverse effects of bailouts occur whether the source of the extra payment comes from the Treasury—financed by taxpayers, from an assessment fund—financed by banks and their customers, or from smaller payments for less favored creditors.
There are other concerns. Under bankruptcy reorganization, private parties, motivated and incentivized by profit and loss considerations, make key decisions about the direction of the new firm, perhaps subject to bankruptcy court oversight. But under Title II a government agency, the FDIC and its bridge bank, would make the decisions. This creates the possibility that the bridge firm would be pressured to grant favors.
In addition, the new bridge firm could have advantages over its competitors due to the Treasury funding subsidy, lower capital requirements, and tax exemptions.
A reform of the bankruptcy code (called Chapter 14).designed to handle the big firms is a better best way to reduce the likelihood of bailouts. The goal of the reform is to let a failing financial firm go into bankruptcy in a predictable, rules-based manner without causing disruptive spillovers in the economy while permitting people to continue to use its financial services.