BLOG: Market Distorting Moral Hazard of Dodd-Frank’s Title II: The Costs of Inefficient Capital Markets

By Charles LeSueur, Vassar College

The purpose of this paper is to analyze whether Title II of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) effectively fulfills the stated goals of ending “too big to fail”, “no more taxpayer-funded bailouts”, and decreasing systemic risk.  I argue that Title II institutionalized taxpayer-funded bailouts under different language and increased systemic risk.  In addition to increasing the moral hazard that Dodd-Frank is intended to decrease, it also distorts financial markets by creating a state favored class of firms that undermines the United States’ historical comparative advantage in innovation driven by efficient capital markets.  The magnitude of the impact of these distortions has received considerable theoretical and empirical analysis via the preferential financial systems of Latin America, compared to the United States, over the past two centuries.  The alternative endorsed is the adoption of the Financial Institution Bankruptcy Act (FIBA) of 2017 and the repeal of Title II of Dodd-Frank.  The benefit is the mitigation of market distorting moral hazard and decreasing systemic risk in the financial system.

This paper only concerns itself with Title II and makes no commentary on the rest of Dodd-Frank or financial regulation in general.

I. Introduction

While entire landscapes have been deforested in the dialectic between various camps of academics and policy makers, the unwavering foundation of economic thought is that growth is contingent on the allocation of resources to their most productive uses.  This paper will argue that, in addition to increasing the moral hazard that Dodd-Frank is intended to decrease, it also distorts financial markets by creating a state favored class of firms that benefit from a competitive advantage.  Title II of Dodd-Frank fundamentally distorts the allocation of factors of production away from their most efficient uses and systematically decreases innovation.  The current economic inequality between the United States and Latin America is the result of compounding returns on accumulated capital via upward pressure on total factor productivity by a comparative advantage in facilitating effective capital markets.  Efficient capital markets allocating scarce credit to the most productive firms incentivizes new methodologies and technologies by new market entrants, forcing incumbent firms to utilize their present resources to invest and innovate in order to remain competitive.

II. Introduction to Title II

Prior to Dodd-Frank, the jurisdiction of the Federal Deposit Insurance Corporation (FDIC) only extended to the receivership of insolvent commercial banks with the intention of protecting depositors and mitigating the risk of runs on banks.  In response to the failure of Lehman Brothers, Bear Stearns, and AIG in the 2007-2008 financial crisis, Dodd-Frank augmented the FDIC’s authority to include investment banks, insurance companies, and any institution meeting the criteria for a Systemically Important Financial Institution (SIFI).  The Single Point of Entry (SPOE) at the holding company level means that the FDIC takes receivership of all subsidies.  This mandate exponentially increases the magnitude of the liabilities of the FDIC beyond the traditional deposits of commercial banks to include vast sums of complicated derivatives.

Title II creates the Orderly Liquidation Authority (OLA) as the vehicle to fund and manage the resolution of SIFIs in the case of failure via risk-based assessment fees[1] on any bank holding company with consolidated assets over $50 billion or nonbank financial companies overseen by the Board of Governors (Klein 2017).  A bridge company is formed that assumes the assets of the failed company and some of the liabilities.  The FDIC is granted significant discretion in administering the liquidation with the explicit ability to treat similarly-situated creditors dissimilarly, such as the prioritization of another SIFI over a non-SIFI creditor, to prevent the perceived spreading of a contagion to other parts of the favored financial system (Taylor 2017; Fisher 2013).  Just the future possibility of this violates the capital stack priority rules that underlie and influence present investor and lender calculations and decisions every day.

During the five-year resolution period, the uninterrupted operations of the failed institution are granted several advantages over competitors under Title II.  First, all preexisting tax liabilities are forgiven and no new ones are levied until the end of the resolution period.  Second, the FDIC is entitled to unlimited borrowing from the Treasury at below market rates to cover the costs of resolution and maintain operations of the new bridge company and all subsidies.  Third, capital requirements can be lower at the FDIC’s discretion.

III. Assessment of Title II

Title II was enacted in recognition of the market failure of the 2007-2008 financial crisis and the need for an effective framework for the reorganization of insolvent financial institutions.  While traditional Chapter 11 bankruptcy has been determined to be too slow and insufficient to handle the largest financial companies, Title II creates perverse incentives and distortions that exacerbate the moral hazard and systemic risk that Dodd-Frank was intended to decrease.  This issue not only directly affects the roughly 5,500 non-SIFI banking organizations in the United States (Fisher 2013) but, as proven by the Great Recession, everyone subject to the functioning of credit markets.  The indirect costs include all forgone aggregate economic growth resulting from non-optimal allocations of factors of production.

Figure 1:


Figure 1, from the 82nd Annual Report of the International Bank of Settlements, indicates that SIFIs benefit from a statistically significant lower cost of capital, whether in the form of lower expected returns on equity or advantageous spreads on long-term debt (Fisher 2013).  This is directly comparable to heterogeneous prices of capital experienced by financial institutions throughout most of Latin America due to effective monopoly rights of favored firms due to just the perception of implicit political protections.  The heterogeneity of prices, based on SIFI status, indicate a misallocation of resources that has been identified to cause significant decreases in output, total factor productivity (TFP), new firm formation, and innovations of new technologies (Banerjee and Duflo 2004; Herrendorf and Teixeira 2011; Gabler and Poschke 2013; and Parente and Prescott 1999).

While Dodd-Frank states, “no taxpayer funds shall be used to prevent the liquidation of any financial company under [Title II]”, the provisions that entitle unlimited borrowing from the Treasury at far-below-market rates, absolve all tax burdens, and include the riskiest of derivatives from non-commercial bank subsidies are legal structures that privatize gains and socialize losses.  This regime incentivizes SIFIs to make riskier investments and creates a fundamentally unfair playing field for all non-SIFIs, especially the commercial banks that the FDIC was originally created to protect (Fisher 2013).  These banks are unable to deliver the artificially outsized risk-adjusted returns on long-term debt and shareholder equity, diverting capital away from healthy, productive non-SIFIs.  Not only is systemic risk increased by concentrating capital in riskier SIFIs, but firms benefiting from monopoly rents have been empirically proven to be more fragile and susceptible to external shocks (Kehoe and Prescott 2002).

In conclusion, Title II fails the stated goals of Dodd-Frank by increasing the severity of the moral hazard and systemic risk of the financial sector.  The incentives created make the probability of another 2007-2008 financial crisis and Great Recession higher than pre-recession and pre-Dodd-Frank by institutionalizing effectively taxpayer funded bailouts under new language. It should be repealed and replaced with a modified Chapter 11 bankruptcy provision for all financial institutions such as that found in the Financial Institution Bankruptcy Act (FIBA) of 2017.

IV. The Importance of Competitive Capital Markets

In addition to decreasing the robustness of the financial system, Dodd-Frank also retards new firm formation, technological innovation, and economic growth.  Due to the artificially higher cost of raising capital and lower possible interest rates cited in section III, non-SIFI designated commercial banks, mostly small- and medium–sized local firms, secure less deposits and make fewer loans than they would in a competitive environment.  There is significant consensus these smaller regional financial institutions historically provide the lion’s share of credit to enable the formation of new firms, new entrants that bring new methodologies and technologies to market.  This competition incentivizes established firms to experiment and invest in the development of new technologies rather than sitting on implicit monopoly rents, increasing total factor productivity (Banerjee and Duflo 2004; Herrendorf and Teixeira 2011; Gabler and Poschke 2013; and Parente and Prescott 1999).

Local capital markets benefit from increased information about and ease of monitoring borrowers, mitigating uncertain future costs of enforcing credit and shareholder contracts.  The effects of institution size and proximity are significant with a 33% increase in the likelihood of a working age individual starting a new business venture, firms near financially competitive credit markets grow 6% faster, and aggregate economic growth is 1.2% higher annually (Guiso, Sapienza, and Zingales 2002).   Competition, combined with the concept that those most able to generate value from a resource are most likely to have the means and incentives to ensure that their right to that property is enforced by institutions, places political pressure on distortionary policy and convergent pressure on prices to more homogeneous input prices.  This would signal that resources are being efficiently allocated to their most productive uses.

Variances in interest rates and individual firm’s’ marginal return on capital indicate massive inefficiencies in the allocation of all factors of production.  Heterogeneous input prices, including cost of capital and decreased risks and costs associated with insolvency, across firms makes the assigning of probabilities of possible futures, and thus returns, functionally impossible to do with any measure of certainty (Restuccia and Rogerson 2007).  Creditors then focus on non-economic means of assessing borrowers such as focusing on the largest, most established firms with political connections that decrease implicit costs of doing business, rather than productivity.  This is the definition of a monopoly right.  The rewarding of capital to less productive firms further disincentivizes the entry of firms with new methodologies and technology, which force established firms to complete, contributing to lower total factor productivity (Herrendorf and Teixeira 2011).  Depending on the author listed in this section, the existence of monopoly rights that distort the allocation of credit account for between half and all of the differences in productivity and wealth accumulation between the United States and Latin America.  Government policies that distort markets into the misallocation of factors of production have been identified as the crucial determinants of the great depressions of the twentieth century (Kehoe and Prescott 2002).  Haber (2005) explicitly traces the historical divergence between the financial development of the United States and Mexico resulting from competitive banking sectors, which were produced by secure property rights and efficient domestic capital markets via processes described above (Rajan and Zingales 2003).

V. Proposed Alternative

The alternative endorsed is the adoption of the Financial Institution Bankruptcy Act (FIBA) of 2017 and the repeal of Title II of Dodd-Frank.  FIBA resolves many of the issues enumerated in prior sections and encompasses the technical recommendations made in the significant work published by the Resolution Project at Stanford University’s Hoover Institution Working Group on Economic Policy.  Under this alternative, all banks would be treated equally and operate on a fair playing field.  The augmentation of the existing Chapter 11 bankruptcy laws to include a new, separate “Subchapter V” for financial institutions would bypass the former insufficiencies that necessitated the creation of Title II without the associated increases in moral hazard and systemic risk.  This new process would remove taxpayer funds from the conversation and remove the institutionalized protection of the riskiest behaviors and subsidiaries of modern financial firms.

FIBA amends federal bankruptcy law to allow financial institutions to choose the new Subchapter V bankruptcy process specific to such institutions.  Similar to the OLA, the new process allows for the transfer of the debtor’s assets to a newly formed bridge company. The trust agreement governing such an assets transfer must meet specified requirements and imposes a temporary stay on actions to terminate or modify contracts with institutions that enter the Subchapter V bankruptcy.  The bill specifies timelines concerning the commencement of a case and the transfer of assets that occur within the span of a weekend, faster than traditional Chapter 11 proceedings. The Securities and Exchange Commission and the FDIC, among other federal regulatory agencies, have standing in a Subchapter V bankruptcy case. It also requires the Chief Justice of the United States to designate at least 10 bankruptcy judges to be available to hear Subchapter V bankruptcy cases to ensure that the necessary expertise is available to handle the complexities of large, complex financial institutions in the required timeframe.

The effectiveness of the proposed alternative can be measured without a financial crisis.  Contraction of the statistical deviations of the costs of capital (Figure 1) and redistribution of depositor market share and industry assets toward small- and medium-sized financial institutions would provide sufficient quantitative evidence of the effectiveness of FIBA.  Not only does this decrease systemic risk via internal decision making, but a less concentrated allocation of industry assets decreases the risk that any one firm can cause systemic damage and contaminate healthy firms in the case of insolvency.  This is most evident in the removal of protection for the riskiest behaviors via the association of a shared holding company with a commercial bank, allowing for competitive capital market enforced discipline instead of the distortion of regulatory imposed discipline.

VI. Conclusion

While Dodd-Frank was passed with bipartisan support in response to a very real market failure and need for an established process to resolve insolvent megabanks after the determination of the insufficiency of Chapter 11, Title II creates counterproductive incentives to the rest of the bill.  With a growing consensus that the severe historical divergence of economic growth between the United States from Latin America centers around differentials in total factor productivity produced by uncompetitive capital markets and the inhibition of the “creative destruction” of new technologies and methodologies.  The rapid convergent growth of Chile within a decade of reforming bankruptcy and banking laws demonstrates the power and speed with which the removal of perverse incentives can rehabilitate capital markets.

[1] These fees are tax-deductible business expenses.


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