Regulation: Too early to tell on too-big-to-fail
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Regulation: Too early to tell on too-big-to-fail

Five years on, Dodd-Frank is suffering from a quiet crisis of credibility.

With much fanfare, the US Dodd-Frank Act celebrated its fifth birthday last month. Hailed as a landmark piece of legislation to ensure the orderly liquidation of financial firms, the act mitigates systemic risks associated with banks’ size, interconnectedness, complexity, cross-border activities and funding, among other things. 


Jeffrey Lacker,
Richmond Fed

Crucially, it establishes ex-ante rules to facilitate firm-specific bankruptcies following the 2008 financial crisis that saw the Fed’s early emergency lending programs, funding for the purchase of Bear Stearns by JPMorgan, and the AIG bailout, reinforce the lack of political appetite to see banks fail. Title II of Dodd-Frank explicitly bans the use of taxpayer money to prop up the top-tier parent of a struggling bank once under receivership.

Dodd-Frank and new Basel rules on resolvability are a marked improvement on the market infrastructure of the financial-crisis era, when the domestic and cross-border resolution of lenders was held hostage to a prolonged legal process of adjudication.

But Dodd-Frank is suffering from a quiet crisis of credibility. Both the bank-funding market and rating agencies continue to doubt that US policymakers will make good on their declaration to end too-big-to-fail (TBTF)

According to research by the Federal Reserve Bank of New York, for example, rating agencies still largely expect US government support for commercial banks. Until Fitch withdrew its presumption of government support for US commercial banks at the eight top lenders in May, the ratio of banking system assets with implicit support has remained stable since 2009 at 50%. 

Standard & Poor’s even reckons the US government will prop up bank-holding companies, with four of the largest – representing a third of all bank-holding company assets in the US – still retaining one notch of ratings uplift relative to the main commercial bank, two notches down from the height of the crisis. 

Second guessing

In theory, of course, investors should price in a higher risk for holding bonds of a parent company relative to paper issued by its subsidiary bank. However, the New York central bank’s research also fails to find any material widening of spreads to reflect this. 

Spreads and ratings might re-adjust soon enough to price in the purported end of TBTF. But resolution will always be a game of second-guessing regulators’ intentions about the political advantages and disadvantages of propping up ailing systemic institutions. 

What’s more, the fact that the US resolution process for banks operates outside the bankruptcy code continues to nurture the impression there is too much supervisory discretion in the liquidation process that risks favouring some creditors over others.

Further reading


Financial regulation: special focus

As Jeffrey Lacker, president of the Richmond Fed, has observed, under Title II, federal authorities have the flexibility to pay some creditors a higher market price for their holdings than under the typical bankruptcy code. They, in effect, can also use government subsidies to facilitate financing the claims of certain creditor groups at the early stage of the liquidation process. 

In addition, Lacker fears the bail-in process – which identifies unsecured holders of bank-holding company debt as the primary losers in liquidation after equity holders – provides too much protection for subsidiary creditors. In sum, the legal system, not just the political system, is perpetuating the too-big-to-fail dynamic.

Living wills – where the largest banks outline a strategy for an orderly resolution within the bankruptcy code – are a better means of determining the resolvability of an operating company. But plans remain a work in progress. If US regulators remain unsatisfied, they are free to demand divestures and material changes to lenders’ structures. European policymakers are now making battle over the latter. 

Five years after Dodd-Frank, the mission to end TBTF might have only just begun.

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