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.)

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