Monday, December 14, 2009

Prudential Divestitures II or III or IV or. . . .

Barney Frank did it. He passed a sweeping financial reform bill entitled The Wall Street Reform and Consumer Protection Act of 2009. Weighing in at 1279 pages, I am sure there is plenty to argue about, and I am sure many of us will be writing about it for years to come. It shocks me, for example, that lawmakers used this crisis, which epitomizes the problems with laissez faire economics, to strip state attorney generals of law enforcement power. The initial reaction has been interesting: Paul Krugman is amazed that no GOP Representative voted for the bill; the unions apparently think it was major victory over monied bank interests; the Mortgage Bankers Association opposes the bill; and the banks' lobbyists spent $300 million and caucused with the GOP in a futile effort to stop the bill. All of this suggests a rare triumph of policy over our money-driven political system. But, I think Ohio Representative Dennis Kucinich makes some compelling points that give me pause, such as the bill's failure to adequately regulate OTC derivatives, the continuation of regulatory power to pursue bailouts of troubled mega-banks, the failure to restructure the regulation of credit rating agencies, and the failure to really reform asset securitizations. So, I suppose on some levels it looks like a mixed bag.

Nevertheless, I was pleased to see that section 1105 of the bill authorizes a new regulatory authority to order divestitures of "business units, branches, assets or off-balance sheet items." I have argued for this power to order prudential divestitures on this blog since July, gave thanks for the Kanjorski Amendment that inserted this power, and formalized my proposal in a forthcoming Dayton Law Review symposium article. So this blog entry constitutes at least my fourth effort to urge our lawmakers to impose this sanction against firms that are too-big-to-fail.

Let me review my argument: Banks that benefit from an implicit government guarantee enjoy a lower cost of capital and are apt to shoulder more risk than if they knew that real insolvency would result to destroy their firms (and the careers of senior managers) in an FDIC receivership or bankruptcy filing. They therefore attract too much capital to fund too much risk system wide. This supports asset bubbles. Bailouts also give managers perverse incentives to fail, for failure can lead to golden parachute and other severance payouts that now are government guaranteed. Firms that are not implicitly guaranteed are forced to compete with government subsidized firms. In short, too-big-to-fail destroys markets across the economy and subsidizes ineptitude. It is socialism for the rich.

Giving the government the power to order divestitures means creditors must risk the possibility that firms they lend to will be cut down to size instead of bailed out. Managers too must be concerned that if they take too much risk they will be in line with all the other unsecured creditors if their firm becomes insolvent.

There are certainly other important issues. And the coming months will tell if the bankers and their hoards of cash (our cash) will prevail.

But the power to order divestitures is a pretty good litmus test--some commentators call it the "biggest threat to Wall Street." If it gets killed in the Senate then look out! The fix is in.


  1. Professor Ramirez:

    Another provocative post. That said, what chances exist that the Senate will not cave to the banking industry lobbyists and kill the very modest proposals for regulation contained in the House bill?

  2. The pessimist within notes that even after any reform bill gets through the Senate (where 100 Joe Liebermans can have at it) it will likely go to a conference committee, where no record is kept and all kinds of secret amendments can be added. My prediction is that the final bill will get diluted from here.