In his article in the Summer 2011 issue of The Independent Review, “The Dilemma of Bailouts,” economist Roy C. Smith (New York University) examines why despite its prohibition of taxpayer-funded bailouts, the Dodd-Frank Act has left the financial system exposed to meltdowns and promotes the shifting of risk from large “systemically important” financial firms to smaller, less-regulated ones.

On May 17, 1984, after a twelve-day “electronic” run, the Federal Reserve Board (Fed), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency jointly announced that they would guarantee “all depositors and general creditors” of Continental Illinois Bank—the country’s sixth-largest bank, with assets of $45 billion—make a capital infusion of $2 billion, and supply any “extraordinary liquidity” needed to keep the bank afloat (Office of the Comptroller 1984). The announcement stunned many policy observers as the group of regulators promised to make whole (that is, to bail out) all of the bank’s creditors, not just those entitled to federal deposit insurance, a step that had never been taken previously. The regulators took this exceptional action because they believed that owing to Continental’s large size and its financial connections with other large banks, its failure might trigger a crisis in the world’s financial system. The regulators knew that many other important U.S. banks had been weakened by a wave of bad loans to industrial corporations, real estate developers, and Third World governments and might also be vulnerable to an electronic run on their credit sources. The Fed acted as it did, according to Comptroller of the Currency Todd Conover in testimony before Congress, because “we could very well have seen a national, if not an international financial crisis, the dimensions of which were difficult to imagine” (Conover 1984). Thus, Continental Illinois was deemed to be “too big to fail,” regardless of existing laws or precedents. . . .

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