Too Big to Fail and the Dodd Bill

by Russ Roberts

in Financial Markets

Mark Warner thinks Mitch McConnell is either a fool or a liar. Ezra Klein reports:

And in an interview in his office this morning, Warner was not too happy with McConnell’s characterization of their work. “It appears that the Republican leader either doesn’t understand or chooses not to understand the basic underlying premise of what this bill puts in place.”

“Resolution,” Warner continued, “will be so painful for any company. No rational management team would ever choose resolution. It means shareholders wiped out. Management wiped out. Your firm is going away. At least in bankruptcy, there was some chance that some of your equity would’ve been retained and you could come out in some form on the other side of the process. The resolution that Corker and I have tried to create means the death of the company. The institution is gone.”

McConnell may be both a fool and a liar, but Warner’s argument is wrong. The death of the institution and the wiping out of equity holders is not the end of too big to fail. It’s the creditors that matter. It’s the bailing out of creditors that creates the moral hazard. And it appears that the Dodd Bill doesn’t solve that problem. Simon Johnson (very smart guy who totally understands how too big to fail lets execs loot their institutions using taxpayer money) also thinks McConnell’s a fool but it turns out he’s only half a fool.

After saying that McConnell is “completely wrong” Johnson writes:

The resolution authority will not end “too big to fail” for large complex cross-border financial institutions. It simply will not – if you think differently, just go talk to our G20 counterparts, as I have done. There is no cross-border resolution mechanism, there is no international process to negotiate one, and there is no chance you will see such a process in the next 20 years.

In other words, the resolution authority in the Dodd Bill doesn’t solve the too big to fail problem. We’re going to end up with ad hoc solution where all the political pressure will be to bail out creditors, the policy we have implicitly followed for the last three decades when large complex financial institutions get in trouble after borrowing too much money. We bail out the people who financed those bad bets.

Johnson’s writes earlier:

Senator Mitch McConnell continues to insist that the Dodd bill creates permanent bailouts – and that it would be definitely better to do nothing.

It’s the second part of the statement that is “completely wrong.” That it is better to do nothing. That might indeed be completely wrong but maybe it was just a rhetorical flourish on McConnell’s part.

Johnson solution is to solve the “too big” part of “too big to fail” by shrinking the banks. (Arnold Kling agrees, btw.) I don’t understand how this would actually work. But for me, the more important point right now is that the Dodd Bill does not seem to solve the too big to fail problem. Yikes.