This is crazy:
the House Republicans on the Financial Services Committee just voted to repeal “resolution authority.”
Let’s review the history. When the crisis hit, the government bailed out many financial firms — shadow banks as they are known. That’s not what it does when an ordinary bank fails. When ordinary banks fail, the government takes over the bank, puts the good assets in one pile, the bad assets in another, then repackages the good assets into a new bank that is sold back to the private sector as soon as possible.
This has many advantages, including the ability to replace managers of failed firms instead of rewarding them with a bailout. So why wasn’t this approach adopted during the financial crisis? The Treasury argues that it did not have the legal authority to take over large shadow banks — these banks fell outside of the existing regulatory umbrella (there is dispute on this point, some people claim the government regulators could have twisted existing regulation to allow this, but government regulators insist otherwise). Thus, government regulators believed there were only two (bad) choices. Let too big to fail banks fail and suffer the economic consequences, or to bail them out, including bailing out the owners and managers who had led the banks to disaster. If it had resolution authority — the ability to step in take over when banks fail — the rewards to management could have been avoided, and taxpayers could have been better protected in other ways, but limits on legal authority gave regulators only two bad options. Do nothing, or bail the banks out.
The resolution authority in Dodd-Frank is intended to fix this problem by putting into place a procedure that is similar to what is done with ordinary banks. Resolution authority allows government regulators to take control of the banks, fix the problems, and then return them to the private sector. But, and this is important to recognize, Dodd-Frank also prevents the type of bank bailout that was done during the financial crisis.
Thus, the authority for the type of bailout that we saw during the crisis no longer exists. If if we now remove resolution authority there will be just one choice if a too big to fail firm gets in trouble — let it fail. That, and the cascading shadow bank failures that would follow, would be a disaster.
I was unsure that resolution authority as spelled out in Dodd-Frank would actually work. If a large, systemically important bank was failing, would regulators have the courage to try this risky new procedure, or would they fall back on what has worked before, the type of bailouts we saw during the crisis? The legal authority to do bailouts is now gone, so a bailout is no longer a choice, but the law could always be altered quickly and I expected that might happen when the next financial crisis hits.
But we need to be able to do one or the other — to bail them out or put them through resolution authority — and resolution authority would be much better if it works. The idea embraced by Republicans that letting these banks fail will prevent moral hazard (banks will take less risks if they know there’s no bailout coming, or if the managers will get kicked out as resolution authority is exercised), but won’t cause a disaster, is nuts. Financial history tells us that failing to step in and do something — a bailout or resolution authority — leads to cascading bank failures and economic disaster. Saying government won’t step in to save a system in cascading failure is not a credible threat. It will step in. So this doesn’t fix the moral hazard the GOP is so worried about, and it likely makes it worse since the moral hazard associated with a bailout is larger than with resolution authority. I am not sure that resolution authority will work, we may still need to do a bailout anyway, but letting large, systemically important banks fail as the GOP would have us do is not a risk we ought to take.