It's not hard to predict how the coming fight over financial regulation legislation will be framed by most of the mainstream media. Democrats like Christopher Dodd, the sponsor of the pending Senate bill, will be portrayed as cracking down on greedy Wall Street operators. Republicans will be portrayed as letting Wall Street operators have their way.
That might be a fair characterization if Republicans concentrate their fire on the consumer protection agency the bill would establish in the Federal Reserve. But that's a peripheral issue, and Republicans would be well advised to leave the opposition to CEOs like JPMorgan Chase's Jamie Dimon, a Democratic contributor, who argues persuasively that regulators should just do a better job of enforcing already existing rules.
The real heart of the Dodd bill is the provision creating a $50 billion fund collected from large financial firms and authorizing the FDIC to use the funds to reorganize any such firm it decides is failing. Under the bill, the FDIC would use this "resolution authority" rather than have the firm go into bankruptcy courts, as Lehman Brothers did after it collapsed in September 2008.
This sounds reassuring. But actually it's very dangerous. It amounts to granting "too big to fail" status to financial firms like Goldman Sachs and JPMorgan Chase. As my American Enterprise Institute colleague Peter Wallison and University of Pennsylvania law professor David Skeel explain in The Wall Street Journal, it tells those firms' creditors and shareholders that Uncle Sam will bail them out if they make what turn out to be imprudent loans.
The Lehman Brothers bankruptcy process was orderly and did not result in the financial collapse of the firm's counterparties in financial transactions. But it did impose severe losses on creditors, shareholders and managers. Players in the financial markets were put on notice that they face dire penalties for placing trust in shaky firms.
FDIC resolution authority would work differently. The Dodd bill specifically authorizes the agency to treat "creditors similarly situated" differently -- i.e., it can pay off creditors who would get little or nothing in bankruptcy proceedings.
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