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Dodd bill too opaque—A Commentary by Jonathan Macey ’82

The following commentary was posted on Politico.com on April 19, 2010.

Dodd bill too opaque
By Jonathan Macey ’82

A major battle between two barons of the Senate pits Banking Committee chairman Christopher Dodd (D-Conn.) against minority leader Mitch McConnell (R-Kty.).

Their face off is over whether or not the proposed overhaul of the financial services industry — the Dodd bill — can put a stop to government bailouts of financial companies.

President Barack Obama entered the fray late last week, saying “I am absolutely confident that the bill that emerges is going to be a bill that prevents bailouts. That's the goal."

Stakes are high.

The apparently endless bailouts, and the crony-capitalism culture that seems to riddle Washington, are politically radioactive.

The Dodd bill is likely to pass if it is seen as an anti-bailout bill. It is likely to fail if it perceived as perpetuating the “heads Wall Street wins, tails Main Street loses" status quo.

Dodd flatly asserts that his bill "as drafted ends bailouts." In sharp contrast, McConnell uses words like "permanent," "endless" and "perpetual" to describe what he called another "taxpayer bailout of Wall Street banks."

The fact that the Dodd-McConnell debate cannot be resolved just by reading the text of the statute reflects the profound opacity of the Dodd bill.

The complexity and even ambiguity also indicate that the statute does not necessarily end bailouts. The same statutory language that gives Dodd room for political rhetoric now gives bureaucrats room for future political maneuvering. There is reason to believe actually that the bill makes it more likely that certain firms, particularly insurance companies, could be bailed out.

It does give regulators new resolution authority over large financial firms, and encourages regulators to take prompt corrective action against insolvent firms.

But regulators have received similar powers before and opted to continue bailouts rather than impose resolution strategies that shut down insolvent firms.

Time and again in the middle of a crisis, we have seen that bureaucrats shy away from winding up distressed financial firms. When the next crisis comes, there may well be another wave of bailouts.

Many people might then ask Dodd what he thinks of these bailouts. And he might say, “That's not what was supposed to happen under my statute." Some may even believe him.

One thing that the Dodd bill does do is increase regulators' discretion and power. The notion that this discretion and power will necessarily be used to avoid bailouts of big financial firms sounds like a pipe dream.

One way the bill purports to end bailouts is by creating a $50-billion fund to pay off the creditors of big financial institutions when such firms are liquidated. The idea is that this money is to fund alternatives to bailouts.

In fact the statute institutionalizes the idea that big financial firms are special and that their creditors deserve special protection. And the $50 billion in the fund is sufficiently small that regulators could plausibly be able to claim that there just wasn't enough money to do liquidations rather than bailouts.

The bill also requires banks, investment banks and insurance companies viewed as posing a systemic risk to submit periodic "funeral plans" -- laying out how they could be wound up in an orderly way if they become insolvent.

The idea here is that bureaucrats won't have to bail out insolvent institutions because they can just follow the funeral plans. Of course, there is no requirement that regulators must follow these plans. And there is no reason to believe that they will.

Meanwhile, the proposed rules give big financial institutions a competitive advantage over their smaller rivals -- whose creditors won't get bailed out if they fold.

The bill also creates a new bureaucracy, or "Council of Regulators," with the authority to identify and resolve problems of systemic risk. Financial institutions like insurance companies, hedge funds and venture capitalists that now operate to some extent without interference from unnecessary federal regulations, could then be brought into the regulatory fold.

But the bureaucrats running this new council could face peculiar incentives. Nobody will ever know if they have intervened too much or too early -- and so destroyed asset values that were legitimate.

But if a financial bubble were ever allowed to burst, the bureaucrats in the council would face intense criticism for having failed in their basic mission. This means these bureaucrats will consistently err on the side of over-intervention.

Judging from past experience, I predict that the regulators will intervene to pop asset bubbles where the asset owners are weak and lack political muscle.

These bureaucrats, hopefully, won't close too many financial institutions when they are actually solvent. But they will certainly close a few of those to be on the safe side.

After all, the whole idea behind this plan is to confront the massive specter of systemic risk. And, when regulators fear an institution is about to become insolvent, or is operating while insolvent, they will bail it out -- to prevent the systemic risk ogre from running amok through the economy.

This is just what happened -- first for Bear Stearns and AIG, then for the hundreds of financial institutions that collected TARP money and for the thousands of banks and mutual funds that got the benefit of a vastly expanded federal safety net.

The Dodd bill may end the concept of "too big to fail." But it’s doubtful.

There is no reason to believe that bureaucrats who decided the big financial institutions were too big to fail in 2008 will not make the same calls whenever the next crisis hits.

On the other hand, the Dodd bill might transform the "too big to fail" concept from a temporary emergency program to a permanent condition.

If this happens we can be sure that the politicians who backed the Dodd bill will assure us that this is not what they intended.

Jonathan Macey, who is on the Hoover Institution Task Force on Property Rights, is a law professor who specializes in banking and finance at Yale Law School.