Legal Political Moral Hazard: Does the Dodd-Frank Act End Too Big To Fail?

Troy S. Brown, Michigan State University College of Law

Abstract

Abstract

In the aftermath of the 2008 financial crisis, Senator Chris Dodd proposed the Restoring American Financial Stability Act of 2010 (the “Dodd-Frank Act”). The Dodd-Frank Act, the result of more than 18 months of negotiation and debate, aims to strengthen consumer protection, and regulate complex financial products. President Obama called the Dodd-Frank Act “the greatest overhaul of Wall Street since the Great Depression.” Among the many changes and hopes for the Dodd-Frank Act is that it will finally end the financial calamity, social unrest, and massive federal bailouts associated with the “too big to fail” concept. The “too big to fail” concept describes the belief that certain entities are so central to the macro-economy that their failure will precipitate widespread financial disaster, and, thus, should become recipients of beneficial financial and economic policies from governments and central banks. Favorable treatment, however, leads to moral hazard, when an entity does not take account of the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions, a perversion of insurance theory.

Conceptually, moral hazard provides a rich perspective for analyzing the consequences of treating shadow banks as “too big to fail.” From this perspective, “shadow bank” institutions, such as Bear Stearns, Goldman Sachs, and Lehman Brothers, contributed to the 2008 financial crisis by adopting risk prone strategies, despite the possibility of collapse, because they relied on the federal government subsidizing their losses, specifically the Federal Reserve to provide bailouts. Thus, shadow banks are encouraged to act with moral hazard long before a federal bailout becomes necessary. First, shadow banks are encouraged to engage in “high-risk” strategies, defined as using extreme amounts of leverage to fund high risky investments during a credit bubble, while taking advantage of weak regulations, ineffective monitoring by public and private stakeholders, and pro-market laws, policies and entrenched relationships. Second, shadow banks use these high-risk strategies to net financial largesse, acquire additional political influence, and become highly interconnected with other companies and industries, characteristics often qualifying it as too big to fail. Third, when that shadow bank’s high-risk strategies bring the prospect of financial collapse it expects the federal government to provide bailouts, given these pro-market laws, policies, and relationships. Fourth, these bailouts provide the impetus for new, but weak regulations that allow for subsequent bailouts, and thus more moral hazard.

Given the decades of treating entities as being “too big to fail” and the corresponding policy inertia, it is fair to question whether the Dodd-Frank Act, in attempting to end the “too big to fail” concept, addresses the moral hazard implicit to it. To that end, passage of the Dodd-Frank Act raises three related questions, which this article will address. First, how does the Dodd-Frank Act purport to eliminate the moral hazard underlying too big to fail? Second, does Dodd-Frank Act, in fact, encourage or discourage moral hazard? Third, are there changes to the framework of the Dodd-Frank Act that would better enable it to end the moral hazard underlying too big to fail?

While many scholars have analyzed the “too big to fail” concept and the causes and consequences of the 2008 financial crisis, there is a dearth of scholarship assessing the collective impact of the laws, policies, and relationships that encourage the moral hazard underlying the “too big to fail” concept in the U.S. financial system. To better enable analysis of moral hazard, this article introduces the Legal Political Moral Hazard (LPMH) model, which utilizes a rating system that measures the extent of moral hazard based on the following five (5) factors: (1) over-speculation and over-leveraging (Minsky-evolution) to become “too big to fail”; (2) 3-dimensional information asymmetry; (3) entrenched relationships and policy; (4) principal-agent separation; and (5) institutionalized government intervention. The LPMH model’s rating system assesses, on a scale ranging from “nominal” to “dangerous,” whether moral hazard is being encouraged. The LPMH model can be used to assess whether moral hazard is encouraged within an industry, entity, or even whether specific pieces of legislation encourage or discourage moral hazard.

In applying the LPMH model to the Dodd-Frank Act, it is clear that, while it takes important steps in attempting to curb the moral hazard underlying too big to fail, it fails to address several of the factors that cause moral hazard and that led to the 2008 financial crisis; therefore too big to fail will continue. First, because the Dodd-Frank Act does not require liquidity requirements and does not break up or reduce the size of large bank-like institutions, it allows shadow banks to become “too big to fail,” thus, encouraging moral hazard. Second, because the Dodd-Frank Act codifies additional information asymmetries that contributed to the 2008 financial crisis it further encourages moral hazard. These codifications include the following provisions: regulatory exemptions for derivatives; allowing banks and investment firms to continue to mask their losses through over-valued assets and esoteric accounting methods; and an absence in the Dodd-Frank Act compelling shadow banks to reveal their financial statements indicating their actual liabilities. Third, because the Dodd-Frank Act does not strip the Federal Reserve, one of the prime culprits in perpetuating pro-cyclical and pro-shadow bank policies, of its bank-supervision roles, it helps perpetuate the same policies that led to the 2008 financial crisis also encouraging moral hazard. Moreover, given the manner in which the pro-shadow bank relationships and pro-cyclical polices metastasized into federal bailouts, it is difficult to imagine that the passage of the Dodd-Frank Act will temper the Federal Reserve’s and Treasury Department’s pro-market policies, which have historically encouraged moral hazard. Fourth, because the Dodd-Frank Act does not restrict the size of shadow banks or the scope of their activities, it allows for more principal-agent separation, which encourages moral hazard. Fifth, because the Dodd-Frank Act authorizes, or fails to prohibit, resort to the same laws that permitted the 2008 bailouts, emergency mergers and sales of entire shadow banks, it further codifies moral hazard.

Given that all five factors in the LPMH model are present, the Dodd-Frank Act “dangerously” encourages moral hazard. As the LPMH analysis demonstrates, the Dodd-Frank Act shadow banks are still encouraged by pro-cyclical policies to act with high-risk strategies, additional information asymmetries are codified, and federal bailouts still exist under the Federal Reserve Act, despite the Dodd-Frank Act. Therefore, the Dodd-Frank Act therefore has not ended the “too big to fail” concept.

This article concludes by recommending that the Dodd-Frank Act be modified to include a counter-cyclical policy framework to better enable it to end the moral hazard underlying the “too big to fail” concept. Such a framework would include: (1) imposing wind-down procedures for highly interconnected shadow banks; (2) implementing random, counter-cyclical shocks to the financial markets by contracting credit to determine system stability; (3) re-implementing some version of the Glass-Steagall Act; (4) creating a independent regulatory body responsible solely for monitoring systemic risk; (5) avoiding governmentally orchestrated ad hoc “deals” in favor of principled actions based on balanced policies; and (6) imposing bank-like capital requirements to all lending entities. Ultimately, the Dodd-Frank Act is certainly groundbreaking for its attempt to regulate under-regulated areas of the economy and correcting polices that had become unquestioned. Arguably, the Dodd-Frank Act has enshrined moral hazard, while attempting to limit the chaos the “too big to fail” concept will cause in the future.