You could almost forgive the Obama Administration’s flawed handling of the Great Financial Crisis response if it hadn’t passed the Dodd-Frank Act.  Unfortunately, it did.

The Act was effectively written by bank lobbyists.  These lobbyists understood the Too Big to Fail banks needed the US taxpayers to be on the hook for future bailouts.  So they took great care to ensure this would happen.

Let me introduce to you Section 1101 of the Act.  It mandates the Fed cannot lend to an insolvent bank.

Wait a second, doesn’t this undermine how the financial system is designed?

Yes!

Regular readers know in 1933 the US adopted deposit insurance.  It did so because the Fed was reluctant to act as a lender of last resort.

Why was it reluctant?  The Fed couldn’t figure out which banks were solvent and which were insolvent.

Deposit insurance eliminates this problem by putting taxpayers on the hook for making sure the loans from the Fed are repaid.

The Fed understood this deal and stepped forward to make loans easily available.

Of course, this wasn’t necessarily good for the banks.  It made the Swedish Model, under which banks recognize all their losses on their exposures to bad debts and bankers are held responsible for their misbehavior, the policy response of choice to a financial crisis.

The Too Big to Fail banks much preferred the Committee to Save the Banks’ choice of the Japanese Model.  Under this model, the banks were bailed out and the bankers were not held responsible for their misbehavior.

So how could bank lobbyists ensure future bank bailouts?

Their answer is Section 1101.  The lobbyists recognized if a financial crisis hit, the Fed would have to lend to the Too Big to Fail banks.  Since the Fed was prohibited from doing so if they were insolvent, the Fed would have to go to Congress and ask Congress to bailout these banks.

This wouldn’t be the first time the Fed had done this.  This is exactly what happened on September 23, 2008 when Bernanke went to Congress asking for funds to prevent another Great Depression.

But isn’t this a moot point because of the Act’s Orderly Liquidation Authority?

No.  Bank lobbyists are not dumb.

The reason for the annual stress tests is to have the Fed saying the banks are solvent.  Therefore, the request for the money isn’t to address the issue of the banks’ solvency, but rather market confidence.  Of course, it is simply a bailout, but with a different name.

The best thing about the Dodd-Frank Act is it isn’t written in stone.  Perhaps the Trump Administration will do the taxpayers a huge favor and get rid of it.