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Hillary Clinton tells Stephen Colbert "yes, yes, yes" she will let big banks fail

Appearing on last night's Late Show With Stephen Colbert, Hillary Clinton touched on a range of economic themes, starting with her desire to increase opportunities for young people and shifting to a critique that Republicans "act like they have amnesia" about what happened to the economy under George W. Bush.

But her most striking statement was a vow that under a Clinton administration, there would be no repeat of the kind of bailouts that characterized the federal handling of the financial crisis in 2008. Colbert asked what would happen if she were president and banks got into trouble again: "Do we let them fail this time?"

"Yes, yes, yes," Clinton replied, vowing to "impose a risk fee on the banks" to make failure less likely, but also reiterating that, fee or no fee, "under Dodd-Frank that is what will happen ... their shareholders have to know that, yes, they will fail."

What Dodd-Frank has done to prevent bailouts

Clinton is referring to the financial reform legislation co-authored by former Sen. Chris Dodd and former Rep. Barney Frank that Barack Obama signed in 2010 and that is in many ways his most underrated piece of legislation.

The law has many moving pieces, but the two most important ones from the perspective of preventing bank bailouts are called single point of entry and living wills.

Single point of entry is a concept developed by the FDIC that should help it manage the failure of a large, complicated bank without destroying the rest of the financial system. A temporary company would come in and manage critical operating subsidiaries while the firm is being liquidated. This would result in the same losses necessary for fairness and justice, without the risks to the broader economy. FDIC-managed liquidation is basically what happens when small banks fail, but pre-Dodd-Frank regulators felt the tools simply weren't in place for the FDIC to manage a diversified financial institution.

Living wills are a new kind of document required by the law, in which large diversified financial institutions are supposed to write down plans that bankruptcy courts could follow in order to manage failure in a quick and orderly manner. Living wills, if they worked, would completely eliminate the need for bailouts, but so far banks haven't actually produced them in a satisfactory manner. According to the FDIC, the first drafts of these "are not credible and do not facilitate an orderly resolution under the US Bankruptcy Code."

A key question for Clinton is how she will manage enforcement of the living will issue. So far, banks have not managed to gain approval for their living wills but also have not faced penalties for having done so.

Republicans want to undo all of this

The term "bailout" is inherently somewhat fuzzy, and Republican critics have decided that any form of orderly liquidation constitutes a "permanent bailout"; removing OLA authority is a major plank of Paul Ryan's budget.

This raises the question of what, in practice, Republicans think should happen if a major bank fails. On the surface, if we remove OLA and repeal Dodd-Frank we go back to the legal situation that prevailed in 2008, where, in theory, bankruptcy courts are supposed to handle failure. This is exactly what was done with Lehman Brothers, sparking financial panic, and then fear of future panics lead to the Bush administration embracing massive ad hoc bailouts.

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