Bailout bill?

Philip Swagel argues that the Dodd bill on financial reform that is working its way toward a vote gives the government the authority to bail out failing financial institutions, thus guaranteeing risky behavior, failures, and future bailouts.

President Obama’s approach, as embodied in Democratic Senator Chris Dodd’s bill, is for discretion and thus for bailouts. Top administration officials state that they will impose losses on counterparties such as lenders to a failing firm. The reality, however, is that the Senate bill gives the government discretion, without a vote of Congress, to put money into a failing firm to pay off creditors. Shareholders will take losses but creditors can benefit from government-provided funds. Regardless of the administration’s intentions, markets participants will understand that the Senate financial regulation bill allows for bailouts, and this will give rise to riskier behavior that in turn makes future bailouts more likely...

A better approach would be a resolution regime centered on bankruptcy. It would impose substantial constraints on the ability of the government to put money into a failing firm. A judge would divide up a failing firm’s resources among its creditors and leave no possibility of a bailout without a vote of Congress. The Federal Reserve could still use its emergency powers under the so-called Section 13-3 authority to lend against good collateral. Enforcing the requirement for collateralized lending ensures that taxpayers are not propping up a failing firm or providing extra payments—bailouts—to creditors (or auto unions)...

here are also middle grounds between bankruptcy and bailout that would considerably improve on the current House and Senate bills. Non-bank resolution authority could be constrained to allow the executive branch to provide only well-collateralized lending to a failing firm and not unlimited discretion as in the Dodd proposal. This would shift emergency lending authority for non-bank firms from the Federal Reserve to the Treasury Department. Such emergency lending could be further constrained by having any lending start a 30-day clock for Congress to approve the action. Failing congressional approval, the intervention would be unwound and the federal lending repaid without a loss to taxpayers (because it would be well-collateralized). A further constraint would be a tripwire that government lending in excess of $50 billion requires an immediate vote of Congress. Together these provisions would give considerable certainty that there would not be unlimited bailouts, while providing the Treasury Secretary with the additional tool to address a crisis.

Ideally we would set up a resolution system that guaranteed that shareholders and creditors took a substantial hit when a financial institution went bankrupt while allowing the government to close the firm and settle its accounts quickly. As Swagel argues, the Dodd bill can be criticized for failing to guarantee pain upfront to the company's stakeholders. Swagel's suggestions, however, seem to involve putting more sand in the wheels of resolution than is advisable. I don't think you can let a situation like the failure of Lehman Brothers or AIG to stay in limbo for weeks or months - in a crisis, the government needs to be able to act quickly and provide some certainty to markets about where the losses are going to be imposed. Because a systemic crisis potentially has such horrific effects for the economy (see 2008, obviously), no promise not to intervene quickly is credible. Suppose we changed the bill along the lines Swagel proposes. What is to stop Congress from passing a bailout bill overriding the law in order to prevent economic armageddon as it did in 2008? We need to recognize that in the case of institutions that are "too big to fail," when push comes to shove there will be bailouts. The best we can do is to regulate and break up financial institutions so that firms that are too big to fail can't take excessive risks, and firms that take excessive risks are not too big to fail.