The Dodd-Frank Act: Tarp Bailout Backlash and Too Big to Fail

Abstract

The Dodd-Frank Wall Street Reform and Consumer Protection Act represents a multi-faceted effort to tackle the problem of financial institutions that may grow so big that their failure would lead to a systemic risk to our financial system. The impetus for these changes was the public’s backlash to the Troubled Asset Relief Program (TARP) bailout and the moral hazard that it created. Financial institutions that do not bear the full costs of their risky activities have no incentive to reduce or alleviate that risk. Dodd-Frank attempts to reverse that moral hazard by clearly providing that these institutions are subject to additional oversight, must provide resolution plans, are subject to asset divestiture, and in the event their failure may still not be prevented must be liquidated without the possibility of reorganization. Moreover, large, systemically significant financial institutions may be stuck with the costs associated with the failure of other systemically significant institutions even if they are not themselves engaging in inappropriate or excessively risky activities. Large institutions will also have a hard cap on how large they may grow through acquisition (rather than internal growth) through the liability concentration provision of the Act.

It remains to be seen, however, whether the Financial Stability Oversight Council (FSOC), created by Dodd-Frank as the systemic risk regulator, will have the political will and foresight to identify the systemically significant nonbank financial institutions, to hold to the $50 billion asset threshold for systemically significant bank holding companies, and whether and under what circumstances the FDIC will exercise the orderly liquidation authority rather than opt for a Chapter 11 reorganization. Dodd-Frank provides a framework for ending too big to fail if the regulators have the will.