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.

By Phillip Swagel at The American

The debate over financial regulation is now focused squarely on the ability of the government to take over a failing financial institution such as a bank holding company or hedge fund—so-called non-bank resolution authority. This is the linchpin of reform because allowing the government to intervene in a crisis will affect investors’ risk-taking behavior from the start—for better or worse. A resolution regime that provides certainty against bailouts will reduce the riskiness of markets and thus help avoid a future crisis, while a reform that enshrines the possibility of bailouts will foster risky behavior and unwittingly make future bailouts more likely. The key choice is thus whether financial regulatory reform gives the government discretion to bail out creditors or instead ensures that these counterparties take losses.

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.

The Dodd bill allows two forms of a bailout, since the government can put cash directly into a failing firm or guarantee its debt. The Dodd proposal is a bailout bill, plain and simple.

A particularly misleading claim from the administration is that the bill is not a bailout because any losses would be recouped through taxes on banks after the fact. The intervention itself is the essence of the bailout, not whether there are losses to the government. Imagine if the Troubled Asset Relief Program was to end up with a profit—not just recouping the money put into firms over the past two years but actually making a return for taxpayers. No one would suggest that the TARP is then somehow not a bailout. Recouping funds after the fact might be a good way to protect taxpayers, but it is preposterous to claim that this makes the Dodd bill anything other than a bailout. The ability of the government to put money into a failing firm and make payments to counterparties at its discretion is what makes the Dodd proposal a permanent bailout authority, not the issue of who pays after the fact.

Moreover, the discretion given to the government in the Senate proposal opens the door to undesirable actions such as allowing the administration to write checks to favored parties. This concern is not theoretical: such mischief took place in the bankruptcies of Chrysler and General Motors, as the two auto companies were used as conduits to transfer billions of dollars from TARP to the president’s political supporters.

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