Pressure is building in Congress to repeal significant portions of President Barack Obama’s signature Dodd-Frank Act, signed into law after the financial crisis of 2008, according to commentary yesterday from Jim Millstein, Jane Vris and Jim Wigand in The Wall Street Journal. In particular, critics are targeting a provision in the law known as “orderly liquidation authority,” which is designed to give the federal government the power to step in and prevent a system-wide collapse during financial emergencies. The idea behind the law was to avoid a future Lehman Brothers — to give federal regulators the ability to liquidate a large financial holding company in an orderly way and thereby avoid triggering the kind of panic that occurred after the investment bank filed for bankruptcy in 2008. Opponents see orderly liquidation authority as a mechanism to protect “too big to fail” banks. They argue that it encourages large financial institutions to take outsize risks with the knowledge that, if those risks lead to the firm’s failure, federal regulators will be there to bail them out. This “moral hazard” argument mistakes how this provision of Dodd-Frank is designed to work. Unlike with the financial bailouts implemented by the federal government in the wake of Lehman Brothers’ collapse, the statute requires firms in need of federal help to wipe out their shareholders, replace their management and force their creditors to take losses ahead of any funds the government may provide to facilitate the liquidation of the failed institution. This is worth emphasizing: If the government were to lose money as a consequence of liquidating a large financial institution, the firm’s unsecured creditors would be wiped out and other banks in the system would have to pick up the tab to make sure the government were made whole. The “safety net” under Dodd-Frank, therefore, is not a safety net for the failing firm’s shareholders, management or creditors. Rather, it is a safety net for the rest of us, intended to mitigate the harm that the failure of a large, deeply interconnected financial institution could inflict on the economy.
