With the imminent enactment of Dodd-Frank, critics are sweeping in from left and right complaining that the measure misses the mark on too-big-to-fail (TBTF) banks. Maybe so, but expecting an Act of Congress to solve TBTF in definitive form for all time is rather like demanding that a Pentagon-reform bill bring world peace. We can hope, of course, but it isn’t exactly a fair way to judge a new law.

On the left, critics – many of them academics who have written long on what they think the most perfect of all possible TBTF solutions – don’t like the bill because it doesn’t mandate TBTF dissolution. This is true, although all of the TBTF banks that have in fact read the bill know how much trouble their business model is in. While the Dodd-Frank Act doesn’t drop the guillotine on TBTF, it fundamentally alters the big-bank business model in ways that will, we think, lead to a natural disaggregation of the nation’s largest players. We should all hope this happens gradually and prudently – any forcible severing of TBTF banks into constituent parts could well lead to a costly rerun of financial-market fragility.

As on the left, the right-sided attack includes many polemics touted as policy solutions to TBTF. The big difference conservatives have with Dodd-Frank is not so much that it doesn’t break up TBTF banks – the right wants the market to do it, although – like the left – the right likes small banks a whole lot better than big ones. Rather, the main point of complaint is that moral hazard remains because some institutions could get help sometime.

Hoping that Dodd-Frank could end moral hazard once and for all is like expecting bills aimed at drunk driving to end drinking too much in bars. Congress can’t eradicate sin and, when it tries – think Prohibition – one gets precisely the type of sweeping solution far more dangerous than judicious policy rewrites.

Dodd-Frank doesn’t end moral hazard precisely because no one could. It does a tremendous degree better on this front than initial solutions from the Treasury and House Democrats – as we said at the time, these initial TBTF proposals were simply TARP under a fresh cover. They would have given Treasury and/or the FDIC almost unlimited freedom to prop up anyone any time for any reason. Now, though the new law mandates early intermediation – no more hoping for the best by captive regulators, at least for the foreseeable future (which is all to which Congress can be held accountable). And, under the new law, if a regulator – captive, confused or caught off guard – misses a big one, the resolution regime offers little succor. Thus, no more Bear Stearns, AIGs, Lehmans, and so on.

Does this mean that no big bank or – our fear – a “shadow” bank – will ever fail again with systemic consequences that force taxpayer intervention? Of course not. Congress simply could not have produced a bill with no safety net, nor should it have tried to do so. If moral hazard had somehow been wiped out in plain sight, it would have found a way to lurk in the shadows of an ever-innovative system with profound financial incentives to out-run the cops. Again, think Prohibition. And, then, be glad that Dodd-Frank, while tough, is tempered.

 

 

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