Did Dodd-Frank Solve the Big Banks "Too Big to Fail"?

September 4th, 2012
in econ_news, syndication

Econintersect: The Richmond Federal Reserve published a study on Title II of the Dodd-Frank Act which authorizes the Federal Deposit Insurance Corp. (FDIC), instead of a bankruptcy court, to administer wind-downs of the too big to fail banks (TBTF).

In response to the financial crisis of 2007–09, Congress created the Orderly Liquidation Authority (OLA), a new regime for winding down systemically important financial institutions (SIFIs) that become troubled. The OLA provisions address two confl icting goals: mitigating threats to the financial system associated with bankruptcy and minimizing moral hazard associated with government bailouts. This Economic Brief compares OLA provisions to bankruptcy procedures. Although the OLA process could be quicker and more flexible than bankruptcy, it may not limit systemic risk without increasing moral hazard.

This study finds open issues with this approach and concludes:

Follow up:

While bankruptcy may be an excellent resolution mechanism for the failure of most corporations, it may not work well for SIFIs. Their balance sheets are opaque, and they depend on short-term funds, so a long automatic stay during the bankruptcy process might create fi nancial distress for the troubled firm’s counterparties. Also, debtor-in-possession funds may be hard to arrange in a timely manner. Because of these weaknesses, handling a SIFI through bankruptcy may risk the stability of the fi nancial system.

The OLA provisions empower the FDIC to adjust the treatment of qualified financial contracts (QFC) and how creditors are paid. But in the attempt to mitigate systemic risk and minimize moral hazard, reducing one inevitably leads to an increase in the other. The one-day QFC exemption fails to resolve potential risks to financial stability, and it falls short of reducing moral hazard. Perhaps most significantly, the FDIC’s ability to pay some creditors more than they would receive in bankruptcy may increase moral hazard in order to reduce systemic risk.

The threat of a SIFI’s failure presents policymakers with a daunting challenge that neither bankruptcy nor the OLA seems capable of fully resolving.

Read the source document.


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