October 19, 2010
Jeff Gordon on the Dangers of Dodd-Frank
Posted by David Zaring

I've been pretty pro-Dodd-Frank on the pixels of this here blog, but Jeff Gordon, writing in the New York Law Journal, has a much more pessimistic view:

The resolution process for failing non-bank financial firms that emerged in the Dodd-Frank financial reform legislation is seriously, even dangerously, flawed. In the next financial crisis, the likely outcome will be serial receiverships imposed on many of the largest financial firms, a nationalization of much of the U.S. financial sector. Apart from disruption to the real economy, this strategy is likely to increase the incidence of financial crises and will dangerously destabilize world financial markets.

These are strong claims and it takes some unwinding to get there. But the argument flows directly from the decision in Dodd-Frank to make an FDIC receivership the exclusive mechanism of providing support to troubled financial firms, stripping away much of the Federal Reserve's and FDIC's prior authority to provide systemic support in a financial crisis. Having entrusted the regulators with enormous discretion in the implementation of Dodd-Frank, the legislation withdraws that trust at the moment of systemic emergency, in the name of eliminating bailouts and stamping out moral hazard.

Jeff and a co-author have a pretty interesting paper suggesting that the financial service industry should pre-fund a one trillion dollar stabilization kitty for just these types of emergencies.  He's not as worried about the moral hazard as is, apparently, the Congress.  But he is concerned with the whole "never again" ethos of Dodd-Frank.  The Fed can't step in by opening its discount window, and the FDIC has to ask around before it can do much other than resolve a failing institution.  If resolution is the only hammer in the toolbox, then every troubled bank will get resolved.  Would we rather have that than what we have now?  Would we rather be Ireland, in other words, instead of the United States?

The point is worth remembering.  I might quibble about parts of the Gordon analysis - the Fed never used its discount window the way it did during the crisis, so I don't mind some guidance, and I would predict not that every bank will be nationalized, but, rather, the reverse side of the USDA Meat Inspector Paradox (they can only shut done the plant or ignore the contamination - they, at least proverbially, can't hand out fines) - regulatory forbearance when faced with shaky institutions.  And I do worry about the moral hazard of a trillion dollar safety net.  But the Gordon approach makes banks pay for their excesses, and if done right, would incentivize them to monitor one another.  It's not clear that the new Dodd-Frank regime does so.

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