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ICYMI: Lehman Wasn't a Crisis, But Too Big To Fail Was


Washington, Jun 30 -

By: Peter Wallison
Real Clear Markets, June 29, 2016

Drafts of a thoroughgoing reform of Dodd-Frank, prepared by House Financial Services Committee Chairman Jeb Hensarling, are now circulating in Washington and drawing the predictable attacks from the anti-reform caucus-otherwise known as the Progressives.

The bill, called the Choice Act, is a massive piece of work-about 500 pages-to be expected if it is to make significant changes in the 2300 page Dodd-Frank legislation. Fortunately, it repeals a lot of the harmful elements of Dodd-Frank and modifies or replaces others.

All this can't be covered here, but two of the most significant provisions are these: the act offers the banking industry a trade; in exchange for increasing capital, banks can attain some relief from the stifling regulation that has thus far stunted the economic recovery.

The trade is particularly interesting because Mr. Hensarling is offering reduced regulation for banks that abandon the Basel risk-based capital rules-in effect in various forms since the late 1980s-and adopt a simple 10 percent tangible assets-to-equity leverage ratio.

This is good for two reasons. First, it will provide the regulatory relief that community banks desperately need; they can stop hiring compliance officers and start hiring lending officers again. Second, the insanely complex Basel rules have proved to be a boon for the largest banks, which can manipulate them so their capital positions look healthy. The market has long recognized this phenomenon and doesn't believe what the banks or their regulators say about their financial strength. The biggest banks, backed by the anti-reform caucus, will protest this change, but it will finally produce a credible regulatory capital system for banks, and eliminate the capital allocation inherent in the Basel rules.

Another of the major reforms is the repeal-yes, repeal-of Title II, the so-called Orderly Liquidation Authority, which gives the FDIC the authority to take over nonbank financial firms if their failure would cause instability in the US financial system. Repealing this provision is good because it is both a source of unnecessary confusion and fails to deal with the real problem of too-big-to-fail.

Title II was supposed to be a backstop when bankruptcy was insufficient to deal with the failure of a large nonbank financial firm. It arose out of the incorrect idea that the bankruptcy of a large financial firm would be as disruptive as Lehman's failure. Certainly chaos occurred after Lehman suddenly filed for bankruptcy, but that was because the government unexpectedly and illogically reversed the big-firm rescue policy the market thought it had established in rescuing Bear Stearns six months earlier. Rescuing Bear was a massive error, compounded destructively by allowing a much larger firm-Lehman-to fail without warning. The result was a turbulent period that we all recall as the financial crisis.

But although Lehman's failure was a shock, no other large firm failed because it was interconnected with Lehman, and it was the false idea that all these large firms are interconnected that gave rise to the notion that they should be subject to special regulation as systemically important financial institutions (SIFIs) and subject to a special resolution system administered by the FDIC.

This is another prescription for chaos, since no one will know, as a large firm begins to weaken, whether it will be resolved in bankruptcy or taken over by the FDIC. Firms in that situation will be unable to save themselves by raising new equity or liquidity, because investors and creditors will not know how their financial assistance will be treated. Bankruptcy provides a roadmap; the FDIC, on the other hand, is a black box.

Perhaps more important, Title II is the basis for the false claim-regularly made by the Obama administration and bruited about by the Progressives-that Dodd-Frank eliminated too-big-to-fail. As I noted, Title II applies to nonbank financial firms, and specifically states that it does not apply to banks. The FDIC had neatly protected its turf with this language, but that means if one of the four giant trillion dollar US banks (and several others almost that large) should fail, it is the FDIC that must resolve it under the banking laws.

The FDIC, however, has earned its reputation in one way, by selling failing banks to healthy ones. It has even done that with large failing banks, selling Washington Mutual to JPMorgan Chase and Wachovia to Wells Fargo in 2008. But that game is now over. The largest banks are already too-big-to-fail, and selling one trillion dollar bank to another will simply make the problem worse.

The only other alternative to prevent the chaos that would accompany the failure of a trillion dollar bank would be to keep the bank open, supplying liquidity while it is gradually either returned to health or sold off in pieces. The FDIC does not have anything close to the financial resources to do that, but we have a name for it: it's called a bailout.

And do you know who will be paying those costs? You guessed it: the taxpayers. And that's either something the Progressives don't know or don't want you to know.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.  His latest book is Hidden In Plain Sight: How the U.S. Government's Housing Policies Caused the Financial Crisis and Why It Can Happen Again (Encounter Books, 2015).  

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