WASHINGTON — Repealing or modifying regulators’ authority to take over failing banks may actually increase the risk of taxpayer-funded bailouts, according to a new blog post by former Federal Reserve Board Gov. Daniel Tarullo.

Tarullo said President Trump’s executive order asking the Treasury Department to review the resolution powers laid out in Title II of the Dodd-Frank Act may lay the groundwork to dismantle a set of authorities that regulators need to resolve a failing firm in a way that does not set of a financial panic.

“A credible resolution option is … central to countering the [too big to fail] problem,” Tarullo wrote on a blog published May 8 by the Massachusetts Institute of Technology’s Golub Center for Finance and Policy. “History … cautions that we should not underestimate the challenge in convincing markets that government authorities really will contemplate failure of a major financial firm — particularly in a period of generalized financial stress. There are really no good examples of systemically significant firms being resolved in a non-disorderly way.”

Daniel Tarullo, governor of the U.S. Federal Reserve, speaks during an event at Princeton University.
Former Fed Gov. Daniel Tarullo, in his first comments since his April retirement, warned the Trump administration and Congress that erasing Title II of Dodd-Frank would create more problems than it would solve. Bloomberg News

Tarullo noted that Trump’s executive order was “careful not to dictate the outcome of the review,” which he speculated might be a political maneuver to give the Treasury cover to “avoid a Congressional rush to judgment” on whether to repeal Title II altogether — something that Congress could accomplish via legislative reconciliation and thus avoid a Democratic filibuster.

But, he said, it is important to understand what impact a repeal of orderly liquidation authority would have on actually limiting taxpayer exposure to failing financial firms. A bank or other financial institution generally fails because its customers — or, more commonly, other financial counterparties — no longer have faith in it and begin to pull their money out. A financial crisis is an extrapolation of that effect, where customers and institutions no longer have faith in the system as a whole.

Bailouts in the 2008 crisis were the only means available for preventing a complete collapse of public faith in the financial system, Tarullo said. Counteracting that effect requires instilling in the public a sense that failing banks will, indeed, be allowed to fail, and to do this, there needs to be a credible alternative to bailouts. OLA is a critical part of that credible alternative, Tarullo said, along with reforming the bankruptcy code and the creation and maintenance of credible resolution plans by the banks themselves.

The blog post marks Tarullo’s first public comments since his retirement April 4 after serving eight years on the Fed’s Board of Governors. Tarullo chaired the Fed board’s supervisory committee and was central to creating the central bank’s regulatory framework in the wake of the financial crisis.

Tarullo said there are two basic objections to OLA: that it offers fewer protections to individual creditors than bankruptcy, and that the line of credit it affords to failed banks amounts to a bailout. On the first argument, Tarullo said the protections are similar to those that have been afforded to creditors of failed Federal Deposit Insurance Corp.-insured banks for decades, and “it is unclear how wide the difference in actual protection” OLA is from bankruptcy law. As for the charge that OLA amounts to an institutionalized bailout, Tarullo said the point of extending a line of credit to a failing institution is to keep those short-term investors most likely to bolt from doing so, thus minimizing the potential for panic.

“The incremental moral hazard created here is pretty small,” Tarullo said. “After all, these funders are by assumption able to run. The whole point is to keep them from doing so. Indeed, the very assurance that this funding is available might reduce the incentive of short-term funders to run in the first place.”

Tarullo added that there could conceivably come a time when OLA was redundant, particularly with advances in updating the bankruptcy laws that would make resolution of a financial firm more orderly. But that time has not at hand, and unilaterally eliminating a regulatory tool without any clear benefit would be unwise, he said.

“Given the untested nature of any instrument for resolving very large financial firms, why jettison another option for a third way between bailout and disorderly failure, at least until an amended Bankruptcy Code had been successfully applied?” Tarullo said. “In the absence of adequate changes to the Bankruptcy Code, repealing Title II would simply be dangerous.”

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