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Moody’s: TBTF Still Operative

Shahein Nasiripour reports that one of the major investor services has concluded that the Wall Street reform bill will not end the practice of “too big to fail,” because mega-financial firms will still remain interconnected, and resolution authority will probably not be able to untangle all the domestic and international obligations in enough time to prevent contagion in the event of another financial crisis:

“[A] key issue that challenges the feasibility of the proposed legislation is that it would not fully eliminate the issue of interconnectedness, nor is it likely that resolution authority could fully eliminate the systemic implications of allowing a large and/or highly interconnected firm to default, especially with respect to large international groups, and it certainly would not eliminate the risk of contagion,” the team of analysts led by Robert Young wrote.

“[T]he interconnectedness and contagion risks would not be completely eliminated, nor would the incentives and tools for regulators and the government to provide support via emergency liquidity or other programs that would continue to be part of the framework,” they noted.

As long as that safety net remains in place, financial firms have no incentive to manage their own risk. They’ll continue to socialize it, in the expectation of a bailout, while privatizing their profits. This, by the way, is why many reformers have focused on size, not just size of certain mega-banks but the size of the entire industry. If you ban certain risky products that have no social utility, and if you make banking a boring activity of encouraging the flow of capital from investors to borrowers, you reduce the impact of the inevitable crisis, and you make it manageable enough that industry would have to pay for themselves.

But nobody expects that an international conglomerate like a JP Morgan could get wound down using solely domestic rules and regulations. Or rather, they shouldn’t. The difference here is between a regulatory framework and a structural change. And those with the most power and influence in the government – as well as the thousands of lobbyists employed to maintain the status quo – believe that tweaking the regulations is all that’s needed, while allowing Wall Street to basically continue the same operations unimpeded.

Moody’s disagrees. I believe them.

UPDATE: Dallas Federal Reserve Bank President Richard Fisher basically said the same thing.

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David Dayen

David Dayen