Sunday, April 17, 2016

Dodd-Frank Continues to Work as Planned

Key portions of the Dodd-Frank bill were devoted to identifying and regulating "Systemically Important Financial Institutions" (SIFI's), which are sometimes referred to as "too big to fail banks" following the Great Recession. Throughout this post I will refer to them as financial institutions because the list of those identified includes insurance companies (i.e., AIG). The reforms contained in Dodd-Frank imposed three regulations on these companies once they have been identified.

1. Capital requirements - which require these financial institutions to fund themselves with a minimum amount of equity rather than debt. They are designed to ensure that they bail themselves out in the event of problems rather than rely on American taxpayers. Avoiding these requirements is the reason cited for why GE and MetLife recently downsized themselves.

2. Stress tests - every year these financial firms are tested for how they would perform in the event of a global recession. In 2015, 28 of them passed unconditionally, Bank of America passed conditionally and two (Deutsche Bank and Santander) failed. Firms that fail their stress tests are required to either re-submit their capital plans or are restricted in payment of dividends to their shareholders.

3. Resolution plans - these are typically called "living wills." They "must describe the company's strategy for rapid and orderly resolution under the Bankruptcy Code in the event of material financial distress or failure of the company." In April 2014, the Federal Reserve Board and the Federal Deposit Insurance Corporation (who are tasked with approving these resolution plans) rejected those submitted by 11 of the largest companies. They were required to re-submit their plans in 2015.

The results of the review of those revised plans came yesterday:
U.S. regulators gave a failing grade to five big banks on Wednesday, including JPMorgan Chase & Co and Wells Fargo & Co, on their plans for a bankruptcy that would not rely on taxpayer money, giving them until Oct. 1 to make amends or risk sanctions.
The move officially starts a long regulatory chain that could end with breaking up the banks.
Some are suggesting that the failure of these financial institutions to submit an adequate living will demonstrates that Wall Street reforms are not working. But I would point out two things: First of all, critics of Dodd-Frank often say that regulatory agencies are too close to Wall Street to adequately implement its provisions. There is certainly a lot of room for that critique in the past. But yesterday's result suggests that the Fed and the FDIC aren't hesitating to hold these firms accountable.

Secondly, this is the process that was put in place by Dodd-Frank to break up the "too big to fail banks" when/if they failed any of the three items above and posed a threat to American taxpayers. The proposal Bernie Sanders is putting forward would pre-empt this process and break them up regardless of whether or not they pose a risk. Perhaps that is something to be considered if your goals are about reducing their political power or punishing them for their past misdeeds. But to the extent that Americans are worried about having to bail them out again, it is important to know the steps that have already been put in place to prevent that from happening.

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