Dodd-Frank Says 'Too Big, Will Fail'

Abstract

Of all the claims made by the proponents of the Dodd-Frank Act, the most important are that the Dodd-Frank Act ends “too big to fail” and that it protects the American taxpayer “by ending bailouts.”One component of intervention of Government to bolster the bank balance sheets during financial crisis in 2008 was the Troubled Asset Relief Program (TARP). Although TARP may have saved the United States economy from a lengthy depression, it was perceived by many as a “bailout” of the banks whose own greed had precipitated the financial crisis. A number of institutions received TARP funds, but two – Citigroup and Bank of America – were identified as “systemically significant” and received additional equity infusions and other extraordinary aid from the government. There were significant concerns that the government’s intervention created moral hazard and that risk taking of financial institutions would remain unchecked if the market believed that the government would intervene if necessary to prevent the failure of the largest financial institutions.On July 21, 2010, President Obama signed the massive Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). But Dodd-Frank responds to TARP and attempts to change the phrase “too big to fail” to “too big, will fail”. Dodd-Frank created the Financial Stability Oversight Council (FSOC) as the new systemic risk regulator, with the authority to identify systemically significant institutions, subject them to additional prudential regulation by the Federal Reserve Board, and to mandate an orderly liquidation without the possibility of reorganization in the event they are not able to remain solvent on their own. Whether this new regime will ever be used and whether it will incentivize bank and nonbank financial institutions to reduce their size and complexity so they will not become subject to it, remain to be seen.