Updated July 29 at 9:29am

Fed official’s remarks signal a shift toward bank reform

Guest Column :
Simon Johnson
This is now the standard line from Wall Street lobbyists: Don’t worry about “too big to fail” financial institutions because the Dodd-Frank Act fixed the problem.

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OP-ED / LETTERS TO THE EDITOR

Fed official’s remarks signal a shift toward bank reform

Posted:

This is now the standard line from Wall Street lobbyists: Don’t worry about “too big to fail” financial institutions because the Dodd-Frank Act fixed the problem.

On Nov. 15, resistance to this industry view came from a surprising place: a speech by William Dudley, the president of the Federal Reserve Bank of New York.

First, Dudley made clear that “too big to fail” remains with us. Some very large financial institutions receive implicit government subsidies in the form of downside protection. This insurance is free of charge and allows them to borrow more cheaply, and presumably encourages them to become even larger.

Second, I was struck by Dudley’s admission that the recently completed first round of living wills has been far from satisfactory.

“We are a long way from the desired situation in which large, complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society,” Dudley said.

Third, Dudley is also perceptive on the difficulty of applying to global banks the “orderly liquidation authority” of Dodd-Frank’s Title II, which parallels how the Federal Deposit Insurance Corporation has handled the failure of banks with insured deposits since the 1930s.

There is no cross-border framework or process for handling the failure of big financial institutions. Thus, when a global financial behemoth is on the ropes, the legal mechanisms for an FDIC-managed resolution won’t work outside U.S. borders.

I also have three serious reservations about some of Dudley’s comments.

First, he says that banks “hold” capital. This is the wrong verb to use because it encourages relatively uninformed readers to think of capital as an asset, rather than what it really is, a liability, or shareholder equity.

We should expect our central bankers to speak clearly and explain issues in terms that people can understand.

Finally, Dudley calls on proponents of breaking up our largest banks – so they become small enough and simple enough to fail – to explain in more detail how this could be done and what the precise implications would be.

There is great irony here. During the debate over the Dodd-Frank Act in spring 2010, genuine reformers such as U.S. Sen. Ted Kaufman, D-Del., did not receive any support from the New York Fed or other officials when he pressed the administration on just that point.

Why is the burden of proof on those who want to return to the proven statutory and regulatory approaches of the past? The onus should be on those who, after a devastating financial crisis, continue to tinker at the margins of the failed regulatory framework. •


Simon Johnson is a professor at the MIT Sloan School of Management, a senior fellow at the Peterson Institute for International Economics and a regular columnist for Bloomberg View.

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