How Dodd-Frank Doubles Down on “Too Big to Fail”

In “How Dodd-Frank Doubles Down on ‘Too Big to Fail'” published in the Wall Street Journal  Charles W. Calomiris And Allan H. Meltzer weigh in on the topic. The article addresses many different aspects of too big to fail. There is, however, one point where I believe many should take issue with the authors: “Several researchers have suggested a variety of ways to supplement simple equity and cash requirements with creative contractual devices that would give bankers strong incentives to make sure that they maintain adequate capital. In the Journal of Applied Corporate Finance (2013), Charles Calomiris and Richard Herring propose debt that converts to equity whenever the market value ratio of a bank’s equity is below 9% for more than 90 days. Since the conversion would significantly dilute the value of the stock held by pre-existing shareholders, a bank CEO will have a big incentive to avoid it.There is plenty of room to debate the details, but the essential reform is to place responsibility for absorbing a bank’s losses on banks and their owners. Dodd-Frank institutionalizes too-big-to-fail protection by explicitly permitting bailouts via a “resolution authority” provision at the discretion of government authorities, financed by taxes on surviving banks—and by taxpayers should these bank taxes be insufficient. That provision should be repealed and replaced by clear rules that can’t be gamed by bank managers. “

This is yet again a rather simplistic solution to a much more complex problem. This concept of convertible debt is rather silly. I cannot imagine anyone buying this debt when the time they will get converted into equity is when the financial institution is a disaster. In order to be compensated for this risk, investors will need to extract a hefty premium from the debt issuer. And even this premium will likely not be enough to encourage large institutional investors to participate. Shoring up the capital base is a worthy cause. But trying to induce investors to participate is an entirely different matter.  The problem will be the cost of this capital “ab initio”. When things are good, banks will be loathe to issue this kind of instrument. Expensive. So what happens? Will the regulator force them to put this capital in place? Don’t these mechanisms already exist? Again, in my view, the problem is a simple one. As Steven M. Davidoff wrote in the New York Times in August 2008 in an article entitled: “A Partnership Solution for Investment Banks?” : “Still, to the extent we are moving into a new regulatory structure, the need to create the right incentives here is paramount. The partnership model for banks may be long gone, but in any regulation to come of the investment banks, regulators would do well to look at the stabilizing element of the partnership model: responsibility.” These solutions do not look at the real problem. Making these guys responsible for what happens. There is no way around it.