Dodd-Frank’s Dangers and the Case for a Systemic Emergency Insurance Fund

In light of the liquidation strategy for failing financial firms set forth in Dodd-Frank, I have now posted a revised version of a forthcoming article calling for a “Systemic Emergency Insurance Fund” to augment the FDIC’s resolution authority. This version, co-authored with Chris Muller, is entitled Confronting Financial Crisis: Dodd-Frank’s Dangers and the Case for a Systemic Emergency Insurance Fund; the paper has been accepted for publication in the Yale Journal on Regulation in Winter 2011.

The paper frames its case for a “Systemic Emergency Insurance Fund” in contrast to the seriously flawed, even dangerously flawed, approach of Dodd-Frank. 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 US 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, but 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 Fed’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.

Here are the particular flaws: First, unlike in the case of a bank receivership, the FDIC will not have recourse to a dedicated fund to avoid a disruptive resolution process. Instead the FDIC must borrow from Treasury (read: the taxpayers). Legislative efforts to raise such a fund through assessments on large financial firms were attacked as facilitating “bailouts” and deleted. The reality, of course, is that the absence of industry pre-funding makes the receivership threat less credible and will encourage regulators to postpone intervention until the firm (and the financial system) reaches a more perilous condition. Taxpayer funding is likely to register politically as a “bailout,” notwithstanding a strong repayment mandate. Regulators will strongly prefer to avoid this route and are likely to provide various forms of regulatory forbearance and non-emergency Fed discount window lending in the hopes of avoiding a firm’s insolvency.

Second, to assist the “orderly liquidation” of firms in receivership, the FDIC has uncapped lending authority and debt guarantee authority. In times of “severe economic distress” the FDIC can provide debt guarantees to firms not in receivership only upon prior Congressional authorization. Unlike in the case of TARP, the FDIC will be unable to say there is no other way to avoid a financial system collapse, because the FDIC’s receivership route provides an alternative way to provide support without further Congressional action. “Receivership” is likely to seem a more attractive option to Congress than what could be characterized as a “bailout,” especially where the authorization level is very high, for example, $1.7 trillion of FDIC guarantees in fall 2008.

Moreover, the effort to persuade Congress to approve guarantee authority of significant magnitude may, like TARP, become an independent source of economic disruption, since such a high visibility political moment is likely to coordinate negative economic expectations. Receivership of troubled financial firms is the path of least resistance; it avoids economic collapse at least political cost. This dynamic will produce nationalization of a broad swath of financial firms that may otherwise be unable to meet their funding and liquidity needs and who thus would become insolvent.

Third, the Fed’s emergency lending authority is constrained in ways that will limit its capacity to provide sectoral relief in a financial emergency. Fed assistance must come through a “broadly available” facility that provides “liquidity to the financial system, and not to aid a failing financial company.” Fed loans must not be made to an “insolvent borrower” and must be secured with collateral “sufficient to protect taxpayers from losses.” These constraints appropriately channel firm-specific relief through an FDIC receivership. But they could also undermine the Fed’s ability to create important lending facilities in a financial emergency. For example, in November 2008 the Fed created the Term Asset Loan Facility (TALF), a $1 trillion facility to support the asset-backed securitization market, a major source of financing for financial and non-financial businesses and for consumer credit. The loans were made against somewhat dodgy collateral on a non-recourse basis; the Fed’s risk was covered with a TARP allocation. Such a facility seems ruled out by Dodd-Frank.

The constraints on the Fed’s lending authority, in combination with the FDIC’s unlimited capacity to lend or provide debt guarantees to receiverships, will add momentum to serial receiverships and financial sector nationalization.

Apart from the economic disruption of nationalization, the threat of nationalization will make financial crisis harder to avoid. Early in the potential progression from financial instability to financial crisis, capital suppliers will withdraw from the entire financial sector, not just from particular firms that seem especially at risk. At a time when financial firms need additional equity or need to rollover debt, capital will become much more costly or simply unavailable. In other words, Dodd-Frank’s nationalization strategy will accelerate the slide from instability to crisis and make financial markets less rather than more stable. Dodd-Frank reliance on receivership may successfully resolve an individual failing firm, but it is likely to exacerbate a financial crisis.

Moreover, the impact on the international financial system by falling dominos of FDIC receiverships could be calamitous. In the effort to assure that no US firm is “too big to fail” and to stamp out moral hazard, Dodd-Frank takes no account of the fact that in the international realm, there are some firms that are “too big to save,” meaning that the size of the financial firms relative to the economy of their national domicile deprives the national regulator of the resources for an orderly liquidation, much less a rescue. Multiple FDIC receiverships could well destabilize such firms. That Dodd-Frank allows no discretion in the regulators for such concerns is why its approach to widespread systemic distress may be aptly labeled the “nuclear option.”

The paper argues for a Systemic Emergency Insurance Fund, significantly pre-funded by risk-adjusted assessments on large financial firms. This forces the industry to mutualize systemic risk in an insurance scheme run by the regulators. The goal is to curb “micro” and “macro” moral hazard without putting the financial system at risk from a prescriptive straightjacket.

The full paper is available for download here.