By Bob Needham
Michigan Law
Financial reforms adopted in the wake of the 2007–2008 global financial crisis have not prevented continuing bailouts, Professor Jeffery Zhang points out in a new paper.
Zhang refers to the problem as “the Mike Tyson theory of financial regulation,” after the boxer’s famous saying, “Everyone has a plan until they get punched in the mouth.” In this case, the Dodd-Frank reforms that looked good on paper have proven to be “too narrow in design and too daunting in practice,” Zhang writes.
His new paper, forthcoming in the Iowa Law Review, explores the reasons that Dodd-Frank has not performed as hoped and considers an alternative. He recently answered five questions on the issue:
1. How common are bank failures these days?
Individual bank failures happen all the time. As I try to highlight in the paper, this is nothing new. In fact, we have a well-oiled system for dealing with these failures.
Supervisors are good at coming in and saying, “Hey, time to close up shop.” Then the FDIC comes in and makes sure all the deposits are good. There are no hiccups for individuals and minimal hiccups for the economy.
However, the worry coming out of the global financial crisis was that the system was on fire, not just one individual bank. Moreover, it was these really large banks and other financial institutions that were wobbly. So the idea was that maybe we should do more to prevent that from happening without resorting to bailouts.
2. You discuss two particular provisions in Dodd-Frank designed to prevent taxpayer bailouts. What are they?
Dodd-Frank in general was a response to the ad-hoc bailouts in 2007 and 2008. The whole idea was to improve the safety and soundness of the entire system and of these individual institutions so that we don’t have these ad-hoc bailouts in the future.
Title I of Dodd-Frank requires the largest institutions to write “living wills”—a plan to resolve a bad situation without asking for government intervention. Title II is a complementary measure that says if Title I proves insufficient, then the FDIC can step in.
In practice, though, these remedies have never been used. It was a worthwhile experiment. I’m all in favor of regulatory experimentation, but if we’ve tried something, after a while we should honestly reassess the weak points and the strong points.
3. What went wrong?
A fear of the unknown. We established these tools, but we’ve never used them. If a house is on fire, and you have no experience with putting out fires, your knee-jerk reaction is to run away.
You’re not going to use a new tool during a panic.
That’s where Mike Tyson comes in: Everyone has an elaborate plan for a crisis—but if you don’t practice, you get a little scared. You abandon the plan and fall back on the familiar. In financial crises, that means resorting to more bailouts.
We saw this in 2023 with the bailouts of Silicon Valley Bank and Credit Suisse. Regulators spent 12 and a half years creating a regulatory framework to not make the same mistakes again. Then you get the stress test you’re looking for in both the US and in Switzerland, and the plan got thrown out the window.
If you ever want this resolution framework to be credible in the eyes of the market, to use it successfully, you’ve got to put it into practice somehow. Otherwise, every time a crisis comes up, we’re going to get that knee-jerk reaction.
4. Your paper suggests that part of the solution is to “practice” on smaller institutions?
Yes—institutions that are still large but not massive. If regulators could use the tools on smaller institutions, they could build confidence but also demonstrate that the tools can work.
Right now, this won’t happen because the thresholds for invoking the tools are so high. We have to lower the thresholds—I’m suggesting institutions of somewhere between $10 billion and $50 billion. Those are big enough to matter, but not “too big to fail.”
5. So if the threshold was lowered, would that be enough, or do we need further changes?
If we really want to make the system safer, that by itself is not enough. If we can lower the threshold, that at least gets us in the right direction.
One other change that might help is if we direct the regulators to actually use the tools.
Congress might have to revise the regulation to make it an automatic process—requiring that unless otherwise determined, you must use the resolution regime. Changing that structure could
help.
Michigan Law
Financial reforms adopted in the wake of the 2007–2008 global financial crisis have not prevented continuing bailouts, Professor Jeffery Zhang points out in a new paper.
Zhang refers to the problem as “the Mike Tyson theory of financial regulation,” after the boxer’s famous saying, “Everyone has a plan until they get punched in the mouth.” In this case, the Dodd-Frank reforms that looked good on paper have proven to be “too narrow in design and too daunting in practice,” Zhang writes.
His new paper, forthcoming in the Iowa Law Review, explores the reasons that Dodd-Frank has not performed as hoped and considers an alternative. He recently answered five questions on the issue:
1. How common are bank failures these days?
Individual bank failures happen all the time. As I try to highlight in the paper, this is nothing new. In fact, we have a well-oiled system for dealing with these failures.
Supervisors are good at coming in and saying, “Hey, time to close up shop.” Then the FDIC comes in and makes sure all the deposits are good. There are no hiccups for individuals and minimal hiccups for the economy.
However, the worry coming out of the global financial crisis was that the system was on fire, not just one individual bank. Moreover, it was these really large banks and other financial institutions that were wobbly. So the idea was that maybe we should do more to prevent that from happening without resorting to bailouts.
2. You discuss two particular provisions in Dodd-Frank designed to prevent taxpayer bailouts. What are they?
Dodd-Frank in general was a response to the ad-hoc bailouts in 2007 and 2008. The whole idea was to improve the safety and soundness of the entire system and of these individual institutions so that we don’t have these ad-hoc bailouts in the future.
Title I of Dodd-Frank requires the largest institutions to write “living wills”—a plan to resolve a bad situation without asking for government intervention. Title II is a complementary measure that says if Title I proves insufficient, then the FDIC can step in.
In practice, though, these remedies have never been used. It was a worthwhile experiment. I’m all in favor of regulatory experimentation, but if we’ve tried something, after a while we should honestly reassess the weak points and the strong points.
3. What went wrong?
A fear of the unknown. We established these tools, but we’ve never used them. If a house is on fire, and you have no experience with putting out fires, your knee-jerk reaction is to run away.
You’re not going to use a new tool during a panic.
That’s where Mike Tyson comes in: Everyone has an elaborate plan for a crisis—but if you don’t practice, you get a little scared. You abandon the plan and fall back on the familiar. In financial crises, that means resorting to more bailouts.
We saw this in 2023 with the bailouts of Silicon Valley Bank and Credit Suisse. Regulators spent 12 and a half years creating a regulatory framework to not make the same mistakes again. Then you get the stress test you’re looking for in both the US and in Switzerland, and the plan got thrown out the window.
If you ever want this resolution framework to be credible in the eyes of the market, to use it successfully, you’ve got to put it into practice somehow. Otherwise, every time a crisis comes up, we’re going to get that knee-jerk reaction.
4. Your paper suggests that part of the solution is to “practice” on smaller institutions?
Yes—institutions that are still large but not massive. If regulators could use the tools on smaller institutions, they could build confidence but also demonstrate that the tools can work.
Right now, this won’t happen because the thresholds for invoking the tools are so high. We have to lower the thresholds—I’m suggesting institutions of somewhere between $10 billion and $50 billion. Those are big enough to matter, but not “too big to fail.”
5. So if the threshold was lowered, would that be enough, or do we need further changes?
If we really want to make the system safer, that by itself is not enough. If we can lower the threshold, that at least gets us in the right direction.
One other change that might help is if we direct the regulators to actually use the tools.
Congress might have to revise the regulation to make it an automatic process—requiring that unless otherwise determined, you must use the resolution regime. Changing that structure could
help.
