Fed’s Plosser Says Dodd-Frank Won’t Curb Too-Big-to-Fail Risks

Federal Reserve Bank of Philadelphia President Charles Plosser said the Dodd-Frank Act may not curb too-big-to-fail banks, and the current mechanism for unwinding failing financial companies may lead to taxpayer bailouts.

The 2010 law should be augmented by enhanced bankruptcy procedures instead by relying on the bill’s procedures for unwinding troubled lenders, Plosser said today in remarks prepared for a speech in New York.

While there are “some merits” to Dodd-Frank, “a more standard bankruptcy mechanism, specialized for financial institutions, would be more effective in addressing the too-big-to-fail problem,” Plosser said. The law’s resolution authority “is likely to be biased toward bailouts.”

Fed officials and U.S. lawmakers are considering new ways to limit the risk that the failure of a large bank will lead to a taxpayer-funded rescue. The central bank is discussing ways to limit the safety net and curtail balance-sheet expansion at the largest banks, while senators from both parties are discussing legislation that would tighten capital standards.

House Financial Services Committee Chairman Jeb Hensarling, a Texas Republican, has said he favors a bankruptcy overhaul over the Dodd-Frank Act’s resolution authority.

Senators Sherrod Brown, an Ohio Democrat, and Republican David Vitter of Louisiana announced legislation last month that would impose a 15 percent capital requirement for the largest banks, saying Dodd-Frank won’t prevent future bailouts.

‘Moral Hazard’

“The current efforts may come up short,” Plosser said. “If we are to end discretionary bailouts and the associated moral hazard problems that they create, we should seek more rule-like methods to resolve failing firms” using bankruptcy.

Plans for the resolution of distressed financial firms under bankruptcy laws, known as “living wills,” have limited effectiveness, Plosser said. The biggest U.S. banks have submitted the first round of the wills to the Fed.

“I have doubts that regulators can realistically expect firms to significantly reorganize their internal structure to facilitate their own demise, certainly not in normal times,” Plosser said. “Preparing a living will may open some firms’ eyes to needless complexity in their internal organization.”

Plosser’s view differs from that of Richmond Fed President Jeffrey Lacker, who said in a speech in New York today that “living wills” outlining how to unwind banks are the best way to prevent more government bailouts.

Too Big

Resolution planning is the “only approach I can envision” to solving too-big-to-fail, Lacker said.

Plosser said large banks should be allowed to fail without placing the financial system at risk and they should meet higher capital standards to avoid becoming troubled.

“Large financial firms, and particularly their creditors, should not be rescued or protected by government guarantees,” Plosser said. “Increased capital requirements can lower the incentive for financial institutions to become systemically important and lower the probability that such firms will fail.”

Plosser, 64, became president of the Philadelphia Fed in August 2006. He was previously dean of the business school at the University of Rochester in New York state. The Philadelphia reserve bank will next have a vote on policy decisions in 2014.

Before it's here, it's on the Bloomberg Terminal.