Blog Post

AEIdeas

Last week, the Wall Street Journal summed up the recent difficulties of the Dodd-Frank Act this way:

It’s been a rough few weeks for President Obama’s signature reform of American finance. Across Washington deep cracks are appearing in the foundations of the Dodd-Frank law Mr. Obama enacted in 2010. A federal judge has knocked down a major decision from Mr. Obama’s Financial Stability Oversight Council. Also, a federal appeals court panel is questioning the constitutionality of Mr. Obama’s Consumer Financial Protection Bureau. On Wednesday regulators officially declared that most of the nation’s banking giants are still too big and too complicated to fail.

These are important steps, to be sure. In particular, it is doubtful that any other designations of systemically important financial institutions (SIFIs) will occur until the appeal process has run its course, and this includes any effort to impose restrictions on activities as well as designating firms as SIFIs. Both entail predictions about the future for which the court in MetLife required evidence. That probably means that there will not be any significant regulatory action by the Financial Stability Oversight Council during the remainder of the Obama administration.

But the Journal, and many others, missed an important symbolic event that also occurred during the past week. In a markup at midweek, the House Financial Services Committee voted to repeal Title II of the act, the so-called Orderly Liquidation Authority (OLA), and sent the repeal legislation to the House floor for inclusion in the budget reconciliation process that is now underway.

This was significant because, when the Dodd-Frank Act was passed, Title II was celebrated as the heart of the act. It would, in the inflated language of its supporters and sponsors in the administration and Congress, put an end to problem of Too-Big-To-Fail (TBTF) by providing a mechanism through which the FDIC could take over and resolve the largest nonbank financial firms without the use of taxpayer funds.

It was a head fake from the beginning, accepted by a financial media without question. However, the TBTF problem did not come from nonbank financial firms; its source is the largest banks — the giant trillion dollar government-insured institutions like Citibank, JPMorgan Chase, and Bank of America — and they weren’t covered at all by Title II. In reality, Dodd-Frank did nothing about these huge institutions, leaving them for resolution by the FDIC if they got into trouble. Since the FDIC has only been successful when it could merge a failing bank to a healthy bank, this was no solution at all. When the failing bank is a trillion dollar problem, selling it to a healthy bank only creates an even bigger TBTF problem. The idea that Dodd-Frank “solved” TBTF—an idea repeated again and again by President Obama, his administration and the sponsors of Dodd-Frank–was either based on ignorance or disingenuousness. Repealing Title II eliminates the one element of Dodd-Frank that its supporters claim was necessary to prevent another financial crisis. Everything else in the act is simply more regulation where none was necessary.

The repeal of Title II will be the most important step in the repeal process.

There might have been some tissue of a claim that Title II created a special mechanism for the resolution of nonbank financial firms, but that was also wrong. There was actually no evidence that large nonbank financial firms needed a special resolution system. Bankruptcy would be adequate — and last week the House enacted bankruptcy reforms intended to cover nonbank financial firms — but even if that were not true, the fact that no other firm failed as a result of Lehman’s failure demonstrated that these large nonbank firms are not so “interconnected” that the failure of one will drag down others and cause a systemic event.

Thus, if we are talking about the unraveling of Dodd-Frank, the repeal of Title II — by eliminating the one provision that has been described as the reason for the act — will be the most important step in the repeal process.