Dodd-Frank I: Section 121 and Prudential Divestitures

I first argued in favor of giving regulators the power to order large banks to divest business units to eliminate or mitigate systemic risk (i.e., diminish too-big-to-fail banks) on July 20, 2009. I followed up on this argument on July 27, 2009 on this blog, and continued the effort in a series of postings over the past year (with a specific emphasis on the Kanjorski Amendment) as well as in a recent law review article. In sum, I suggested that this issue would be a litmus test for the sturdiness of financial reform in general or, on the other hand, the sway of lobbyists on the bill. My prediction was that the part of the house bill that authorized divestitures would be diluted relative to the original section 1105 of the House Bill which itself was a watered down version of the Kanjorski Amendment. One year down the road from my original post I am saddened to report that the divestiture provision has been hopelessly compromised.

The good news, as MIT Professor Simon Johnson highlights, is that the final Dodd-Frank Act includes a provision, section 121, that authorizes the divestiture of "assets or off-balance sheet items." As a foremost expert on the intersection of economics and concentrated economic power (particularly insofar as the financial crisis is concerned), Johnson is also clearly correct that this section holds the potential to be a game-changer, in that it can operate to fragment our excessively concentrated financial sector and diminish their political sway in Washington, D.C., as well protect our economy from another financial meltdown like the fall of 2008. Johnson takes a long view: he compares this new power to the Sherman Antitrust Act, which only reached its full potential 20 years after its enactment when the government used it to break up Standard Oil.

The problem is I seriously doubt we can wait 20 years. The plague of the megabanks is now. Our economy teeters on the edge of a deflationary downdraft, the financial sector faces a range of threats from across the world, everyone seems to be hoarding cash now, housing is a catastrophe waiting to happen, and the employment picture is about as grim as ever as manifest in the civilian employment ratio. At the core of all this lies a deeply dysfunctional banking system that seems busily hiding losses on zombie loans while hoarding vast capital.

So what does section 121 of the Dodd Frank Act offer today? Very little, I fear, and much less than the House version. Most importantly, the House bill gave divestiture power to the new Financial Stability Oversight Council (FSOC) based upon a simple majority vote. Dodd-Frank requires a 2/3 vote of the FSOC as well as certain trigger determinations by the Federal Reserve Board of Governors. Thus, no divestiture can proceed without the Fed. Yet, the Fed has been instrumental in facilitating the emergence of too-big-to-fail (TBTF) banks. The Fed also expanded the scope of its lending under section 13(3) of the Federal Reserve Act beyond all recognition in bailing out too-big-to-fail firms like AIG. Thus, the Fed seems poorly situated, in terms of its legal structure, to head off TBTF bailouts. Combined with the super-majority requirement at the FSOC, I recommend that no person hold their breath waiting for divestitures to be ordered.

There are further technical issues presented by section 121 that were not present in the original House version. For example, there must a determination made that other mitigatory actions are "inadequate" for addressing threats to financial stability. The House version authorized the FSOC to "deem" other actions inadequate. Presumably, these determinations would be subject to review under an abuse of discretion standard while the House's language implies a decision to commit the adequacy of other measures to the discretion of the Fed. The final version therefore gives banks an argument to use in court to seek an order that divestiture be a last resort instead of leaving the issue solely up to the Fed.

Finally, I wonder why the final Dodd-Frank provision deleted the clause "selling, divesting, or otherwise transferring business units" from the original House provision. Clearly, it would be a huge reach for any court to buy an argument that the deletion of that language limits the Fed to only ordering the sale of assets other than subsidiaries or business units (since subsidiaries and business units are assets), but it does create some question.

In all, section 121 as finally enacted materially dilutes the original House provision for prudential divestitures. That means that there simply is no viable mechanism for breaking up the megabanks, at least in the short run. We will almost certainly regret that because these banks simply have too much political and economic power, and they are costing us trillions in social wealth. I hope I am wrong. Nothing would please me more than to see the Fed announce tomorrow, immediately after the bill is signed, that they will be seeking to immediately break up the megabanks under section 121. I really doubt that will happen.