Too big to fail, systemic risk and the Dodd-Frank Act

Systemic risk will easily widespread in a system where the financial industry is highly complex, interconnected and governed by several Large and Complex financial institutions (LCFIs). The cost of rescuing giant banks may be too great for the taxpayers’ purse, and the awareness of their systemic importance may encourage them to take greater risks, which is essentially the moral hazard problem.

   The Dodd-Frank Act creates the Financial Stability Oversight Council in order to manage the potential systemic system, and empower the Council with the authority to designate nonbank financial company as systemically important. Such mechanism also orders the bank holding company with assets of $50 billions automatically designated as systemically important. Bank’s activities are across the border of commercial banking and investment banking in nowadays and partly hidden behind the larger scale of derivatives transaction, in particular the C.D.S.  By integrating the regulators from different agencies into a committee process can enhance their conversations as well as supplement some loopholes that failed in drawing their attention in the past. Nevertheless, through singling out the systemically important financial institutions, the government essentially create certain forms of moral hazard and which in turn dampen the “too big to fail” problem through signaling a message to the public that the government will never let those banks fail. For those designated banks, they can easily get the funding and capital with comparative low costs and thus are encouraged to take greater risks.

Besides, the Dodd-Frank Act also provides the so called “Volcker Rule” which prohibits banking entity from engaging in proprietary trading and from acquiring ownership interest in or sponsoring a hedge or a private equity fund. Some exemptions are not without deficiency. The most serious one is the exclusion for transaction that was made for customers. What constitute a trade for the benefit of a customer is unclear. A bank can basically use client activity as a cover for basically anything they are doing. Still, a bank’s investment in hedge fund and equity funds are defined as “de minimis” and excluded from the ban so long as the bank does not own more than 3 percent of any fund. Most commercial banks will be able to fit within the 3 percent limitation without any significant shedding of  assets. Volcker Rule and its bother Swap Push-Out (Lincoln Amendment) are a compromised form of the returning of Glass-Steagal Act of 1933. They aim to remove the investment banking operation from the commercial banking through creating some regulatory “stimulus” in an implicit and indirect manner. Separation between retail banking and wholesale investment banking could take various forms, depending on where and how sharply the line is drawn. I think the Ring-Fencing on the retail banking operation that was proposed by the interim report of the ICB in UK is a form that the US can learn something from. By requiring the retail banking operation be carried out by a separate subsidiary within a Banking Holding company or a universal bank (“subsidiarization”) and still allowed to transfer their capital freely to other banking activities, such form, although may not be best for promoting the financial stability, which I think can reduce the contagion of systemic risk while at the same time impose the banks with least costs.

There are still some provisions which I believe well address the “too big to fail”. Orderly liquidation and the “living Will” requirement are the mechanisms that allow the government has more tools to prevent the failure of a distressed bank will not be contagious to other one. The creation of Office of Financial Research also equips the regulators with more information to detect the systemic risk and the wisdom to supervise and adequately react when a financial crisis is going to burst.   

    

Even given the efforts put in the Dodd-Frank, I still believe the government will bail out the failed financial institutions again. If the government has done everything from systemically designation, stringent capital requirement, proprietary trading prohibition, and to the orderly liquidation (even implemented as good as what the FDIC articulated in the “liquidation on Lehman under the Dodd Frank” report), but still can not prevent LCFIs from collapse, do you think the government will choose not to bail them out to prove a bank’s failure can still be disastrous even under the all mighty Dodd-Frank Act or choose to bail them out then try to justify it is inherently inevitable given the complex nature of modern financial system?