According to this morning’s press reports, Dodd and Lincoln have agreed to bolt together their bills. The Lincoln bill passed by the Senate Ag Committee would become the derivatives title of the Dodd financial “reform” legislation. Crucially, according to these reports, the no Federal assistance/derivatives dealer spinoff/Volker plan on steroids will become part of the Senate bill.
Perhaps maintaining the spinoff is simply a negotiating ploy. Republicans are likely to filibuster the bill, because it is not bipartisan. Negotiations are ongoing. One common negotiating ploy is to include outrageous clauses, that one can generously sacrifice during negotiations.
But maybe it isn’t. Maybe Dodd and Lincoln believe in this insanity. And it is insanity.
I’ve mentioned some of its scary features. But I haven’t mentioned all of the frightening implications. Derivatives markets are intended to provide risk bearing capacity and liquidity. To do so, those making markets must combine trading talent, valuation expertise, and risk capital. One of the reasons that dealers came to dominate OTC markets is that they were able to offer this combination. Crucially, their balance sheets provided the risk capital that made traders more willing to deal with them than other potential counterparties. Dealers assemble networks of positions backed by their capital. There are economies of scale and scope. Prevent financial institutions from backing derivative deals with their balance sheets, and it will be impossible to exploit these economies.
It is interesting to recall that many financial institutions set up bankruptcy remote, separately capitalized, AAA derivatives trading subsidiaries. But market participants preferred to trade with banks directly, thereby having recourse to the banks’ balance sheets. That is, the market once upon a time had a choice to trade on something like that contemplated in the Lincoln bill, and consciously chose not to.
The spinoff clause is therefore likely to impair the liquidity and risk bearing capacity of the derivative markets. (Perhaps, from the perspective of Lincoln and those of like “minds”, this is a feature, not a bug.) Moreover, it is likely to result in more counterparty risk, as less-well capitalized intermediaries replace the banks.
I’ve focused on the derivatives aspects of the Senate bills, but there’s plenty more to hate in the Dodd bill. Let me comment just briefly on the resolution aspects.
The $50 billion dollar “bailout fund” has drawn the most attention, and the most fire, but it’s small beer compared to other things in the bill.
Most importantly, as I’ve noted repeatedly, the fundamental source of too big to fail is the inability of the government to commit not to bail out creditors of a failing or failed institution. Increasing the discretion of authorities responsible for resolution reduces ability to commit.
And the Dodd bill does just that. It gives the FDIC and the Treasury and the Fed tremendous discretionary authority to make creditors whole on the taxpayers’ dime. This discretionary authority is almost completely free from any Congressional check. Moreover, this authority has effectively unlimited access to the public purse.
To sum up: instead of constraining regulators’ ability to bail out creditors of big financial institutions, the bill expands their discretion; instead of increasing the credibility of commitments not to bail out by limiting access to government funds, the bill undermines credibility by giving the Fed and the executive branch virtually completely discretionary authority to pay as much as they want to the creditors of large financial institutions.
Sure, the bill also mandates greater prudential oversight, but this is unlikely to be sufficient, as a litany of past failures of such oversight should make plain. That is tapping on the break, while the measures I just described are flooring the gas pedal.
I know it’s tiresome to hear it yet again, but it bears repeating: the source of TBTF is the implicit subsidy to creditors that exists when the government cannot pre-commit credibly not to bail them out. The Dodd bill basically says in flashing neon: We Will Bail Out Creditors!!! Regulatory discretion plus unconstrained access to the Treasury is a recipe for systemic risk.
If, heaven forfend, the Dodd bill passes, keep an eye on the difference in the funding costs of big financial institutions and small ones. If my analysis is correct, that difference–which is already substantial–will remain wide, and likely grow.
There is of course a conceptual link between the derivatives and bailout provisions. Big derivatives dealers will take on too much risk, to the extent that they are subsidized via the TBTF features of the bill currently slouching towards passage. But the right way to address that problem is not to hive off derivatives trading from the banks that get the implicit subsidy. If they can’t take advantage of the subsidy via derivatives trading, they’ll just take advantage of it some other way. Believe me, there are an infinite number of ways that smart bankers can exploit the subsidy to the fullest; close off one way, they’ll find another. The better way to go is to take measures to reduce, and substantially so, the TBTF subsidy. This the Dodd bill does not do: in fact, it does the opposite.