Did Dodd-Frank Achieve Its Stated Goal of Ending ‘Too Big to Fail’?

The Dodd-Frank Act still allows the Fed to make some of the same emergency lending programs used in the aftermath of the 2008 crisis despite the legislation's stated purpose of ending such bailouts, according to a study by Norbert J. Michel, Research Fellow in Financial Regulations, the Institute for Economic Freedom and Opportunity at the Heritage Foundation.

Michel called the fact that the Fed is still allowed to make such emergency lending "perhaps the biggest mistake of Dodd-Frank."

"Congress should restrict the Fed to providing system-wide liquidity on an ongoing basis," Michel said. "The Fed does not need emergency lending authority to conduct monetary policy."

The purpose of Title XI of Dodd-Frank as stated was to restrict the Fed's emergency lending ability, thus protecting taxpayers from future bailouts. Title XI essentially forces the Fed to adhere to the classic prescription of the lender of last resort (LLR) policy developed by longtime editor of The Economist Walter Bagehot in the 19th century. The classic LLR policy is characterized by two norms: The central bank should prevent panic-induced contractions of the economy's supply of money, and the central bank should provide short-term, high-interest loans to solvent institutions that provide good collateral.

"Congress should restrict the Fed to providing system-wide liquidity on an ongoing basis."

"[T]he central bank ensures that the entire banking system has enough liquidity (base money) to prevent a panic from spreading to the broader economy," Michel wrote. "However, the classic prescription made clear that a central bank had no duty to save specific firms. To avoid sustaining insolvent private banks, the central bank was to provide temporary, high-interest-rate loans only to borrowers who could post sound collateral."

The Fed carries out the role of LLR for the U.S. economy through three functions: emergency lending, discount window loans, and open market operations. Broad-based emergency lending programs resulted in the Fed lending a total of $16 trillion during the 2008 financial crisis, which is a type of lending that perpetuates the too big to fail problem, Michel said. Despite this, Dodd-Frank allows the Fed to conduct that type of lending."

"Congress should restrict the Fed to providing system-wide liquidity on an ongoing basis," Michel said. "Emergency lending authority is unnecessary for conducting monetary policy."

To achieve this, Michel said Congress should:

• Revoke Section 13(3) of the Federal Reserve Act, which authorizes the Fed to lend to "any participant in any program or facility with broad-based eligibility” in “unusual and exigent circumstances."
• Close the Fed's discount window, which is a "relic of the Fed's founding and is no longer necessary," according to Michel.
• Improve system-wide liquidity by replacing the primary dealer system, which currently requires the Fed to depend on a small number of large firms, thus reinforcing the tag of "systemically important."
• End the FDIC's authority to provide guarantees. The FDIC used its systemic risk exception contained in Section 13(3) of the Federal Reserve Act to guarantee hundreds billions of dollars worth of loans immediately after the 2008 crisis. Michel said the systemic risk exception should be eliminated.
• Retain and expand key Dodd-Frank transparency improvements, such as the provision that authorizes the Government Accountability Office (GAO) to audit the Fed's emergency lending programs and requires the Fed to post the results of key GAO audits on its website.

"Little evidence suggests that Federal Reserve emergency lending to individual institutions is either necessary or proper, but such lending clearly politicizes the Fed’s monetary policy," Michel wrote. "Merely restricting the Fed’s emergency lending leaves intact the notion that the Fed should bail out firms—a dangerous view, to say the least. Title XI of Dodd–Frank failed to end the too-big-to-fail problem largely because it retained this belief."

Click here to read the entire study.