Once upon a time, President Donald Trump vowed to “do a very major haircut” on the Dodd-Frank Act. After a lengthy review, his officials have apparently concluded that the 2010 law’s approach to the failures of large banks was about right.
The 2008 crisis showed how dangerous it can be to let a big, interconnected financial institution go bust. When the U.S. tried that with Lehman Brothers, the repercussions were disastrous. Within months, the government was supporting vast swaths of the financial industry, including money-market mutual funds, AIG and the country’s largest banks.
In response, Dodd-Frank created a tool aimed at making big failures more manageable. Known as the orderly liquidation authority, it allows regulators to keep myriad operating subsidiaries running – with the help of government loans – while shoring them up at the expense of the parent company’s shareholders and creditors. Ideally, a newly recapitalized enterprise emerges.
The mechanism has flaws. It’s untested, for one thing, and it’s unlikely to work in a full-blown crisis – when multiple countries are involved, markets are volatile and nobody knows exactly how insolvent financial institutions really are. It might be able to handle the failure of a single bank in otherwise favorable circumstances, but anything bigger would probably require a blanket government guarantee to prevent panic.
Yet even if this part of Dodd-Frank could be improved, the Treasury Department’s review has come up mostly empty. In a 53-page report, the biggest proposal is to adjust the bankruptcy code so that it’s better fitted to financial institutions. The Treasury also suggests changes to the authority itself.
The effort illustrates, once again, the crucial point: There’s no good way to let a systemically important financial institution fail. That’s why it’s vital to make such failures as unlikely as possible, by requiring institutions to have enough equity capital to absorb even severe losses. In this, despite improvements since the crash, the U.S. still falls short. The Federal Reserve Bank of Minneapolis estimates capital requirements would need to more than double to lower the risk of failure adequately.
Bloomberg View editorial.
