A provision of Dodd-Frank designed to protect taxpayers from future bank bailouts caused a stir on Capitol Hill Wednesday.
Title II of the Dodd-Frank Act has analysts wondering if procedures designed to deal with troubled financial firms will be ineffective in curtailing excessive risk taking.
The House Financial Services subcommittee on Oversight and Investigations discussed these concerns over Title II Wednesday.
Under Title II, the Federal Deposit Insurance Corporation allows the government to sell parts of troubled financial institutions to bridge firms when they’re facing default.
“During this [five-year] period, the bridge institution has major competitive advantages as compared to other financial institutions, such as funding from the United States Treasury,” said David Skeel, a professor of corporate law at the University of Pennsylvania Law School.
“Title II was designed to provide an alternative to the Bankruptcy Code to ensure that the tools are available in a crisis to close the largest financial companies and to impose losses on their shareholders and creditors, while mitigating the potential for more widespread dislocations in the financial system and economy,” Michael Krimminger, a partner at Cleary Gottlieb, added.
However, Skeel noted a couple problems with the “single point of entry” statute, which allows the FDIC to transfer all of a company’s assets while leaving its long-term debt.
He said the clause protects banks and encourages them to use even more of the derivatives, and ultimately, does not address the issue of too big to fail.
Additionally, John Taylor, a professor of economics at Stanford University, said “The expectation of bailouts of creditors weakens the incentives for them to monitor their loans and thereby provide this constraint on risk taking.”
He expanded saying, “Because the bailout reduces the risk incurred by large creditors expecting to be favored, they charge a lower interest rate, creating the subsidy of big financial firms.”
Meanwhile, Title II is supposed to eliminate banks being bailed out by taxpayers.
Krimminger explained that the statute flatly prohibits the use of this funding as a means to shift losses of the failed institution to taxpayers.
Despite the prohibition, Joshua Rosner, managing director at Graham Fisher & Co., says it’s possible taxpayers will still end up paying for the creation of further subsidies.