Viewpoint: The Financial System’s Too Fragile to Do Without Title II

By Karen Shaw Petrou

Are “too big to fail” financial companies a fact of life?

A lot of folks say they are, arguing that the Dodd-Frank Act didn’t do diddly to cut big banks down to size. This will fuel calls from the left and right to revisit Title II, the “orderly liquidation” provisions in Dodd-Frank, and to repeal them in favor of bankruptcy for all, including the biggest of the big.

If this movement gets going — and we fear it will — the U.S. could find its financial system further destabilized without any meaningful dent in moral hazard. And, without what little soft landing Title II provides, U.S. financial markets could lose considerable ground to other nations, where TBTF remains de rigeur.

Title II in the new law establishes an orderly-liquidation authority to support systemic financial companies only — repeat only — if regular bankruptcy won’t work due to systemic damage. A tough approval process is invoked to ensure the new authority is used, if ever, sparingly. And should it be used, creditors still need to take the hurt, as do shareholders, management and the board. The scheme is punitive, based on the view (originating with the Bear Stearns and AIG rescues) that big banks can gamble with taxpayer money and, should the bet go bad, let other big banks pick up the pieces at undue profit.

But is this really all that systemic risk means? In fact, financial systems go awry for many reasons, not just the sins of financial-institution gluttony and regulatory coziness that brought down global banking this time around. Thus, too brutal an approach to bankruptcy for the biggest financial companies could destabilize U.S. markets and threaten the economy. That’s why Title II’s provisions that permit establishment of a “bridge” institution after a big firm has been seized are critical not just to orderly resolution, but also to a stable financial system.

All of the debate about systemic risk has focused on TBTF institutions because some of these brought global finance to the brink in this crisis. However, a lot of havoc was wreaked by small firms — think the far-from-systemic subprime mortgage banks and then of all the midsize financial institutions around the world that failed to do the littlest bit of due diligence as they demanded ever more private-label mortgage-backed securities to fill their barren coffers. It’s worth recalling too that the U.S. money market fund that helped bring global finance to the brink in the fall of 2008 was, at best, a minor money market fund. It was contagion risk, not size, that threatened systemic risk when this bit player blew a fuse.

And, there’s another kind of systemic risk: 9/11. When the planes hit the tower, they knocked out a critical part of the payment infrastructure. The Federal Reserve stepped in with billions as the banking system struggled to remain operational. Heroics kept the global financial system afloat, heroics that succeeded in no small part because the most damaged part of the critical financial infrastructure was one big bank. If it had instead been one big investment bank or a major nonbank clearing house, the outcome could have been very different and far worse in terms of the damage the terrorists were able to inflict on the economy.

Sometimes, systemic risk doesn’t come from the moral lapses that lead to moral hazard. It can come from operational risk like that experienced on 9/11 or from contagion risk. Some sources of systemic risk are immune to moral hazard because they are human evildoers or natural disasters. Other sources are seemingly too small ever to be TBTF — that is, until markets are so fragile that even the threat of a crack causes chaos.

Some have called Title II a honey pot, saying it still lets the U.S. government save the biggest financial companies while small fry are exposed to the exigencies of the marketplace. But Title II is a stringent law, creating a resolution regime that is bankruptcy in all but one respect: to prevent systemic chaos the Federal Deposit Insurance Corp. can establish a bridge institution to operate in lieu of the failing firm until danger is past. Should any of this cost the government, then big firms, not taxpayers, pick up the tab.

This tough-minded U.S. approach is dramatically different from those under consideration in the EU and other nations with global banking organizations. Instead of shutting down the biggest banks, policymakers there want procedures to ensure that investors are at risk (“bail-in” debt) and that taxpayers are reimbursed in advance for any rescues through new taxes on the biggest banks. Instead of ending TBTF, these policies memorialize it. As a result, there’s already a wide divide between U.S. law in the wake of Dodd-Frank and TBTF in other major financial centers. The only common thread is the U.S. bridge institution, which provides some comfort that, under stress, a major U.S. bank, financial company or financial market utility would not have its lights suddenly turned off. This is as it should be if financial regulation protects as it should — innocent customer, borrower and financial institution.

If a renewed bout of anti-TBTF fervor takes hold in the U.S., then the cables suspending the bridge in Title II could well be cut. If so, the U.S. won’t have any moral hazard, but we also might not have a resilient financial system able even under stress to offer the services on which global finance depends.