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Too Big to Fail Still Looms, a Year After Dodd-Frank

In addition to being the launch date for the Consumer Financial Protection Bureau, this is the one-year anniversary of the Dodd-Frank financial reform law. I wrote yesterday about how the law has not really caused much of a ripple on Wall Street. Let’s hone in on one, maybe the most important, aspect of this: ending the insidious concept of “too big to fail.”

The Wall Street Journal takes a look today at whether Dodd-Frank ever formally ended too big to fail.

Regulators and administration officials argue that the law has effectively ended the phenomenon called “Too Big To Fail”—the idea that a company is so large and interconnected that its collapse could harm the whole financial system, essentially guaranteeing a bailout.

Regulators say the Federal Deposit Insurance Corp. now has the tools to safely wind down such a large, failing firm, and that Dodd-Frank effectively outlawed bailouts. The FDIC has finished several rules implementing the new regime and is hiring to staff a new office focused on the most complex financial firms […]

Most observers say the matter isn’t nearly so simple. “We have a down payment, is the way I would put it,” said Eugene Ludwig, a former U.S. comptroller of the currency and chief executive of the Promontory Financial Group, a consulting company.

A recent report by rating firm Standard & Poor’s has inflamed the debate, saying Dodd-Frank hasn’t changed the market’s belief that extraordinary government support for some large firms is still possible.

I come down more on the side of Ludwig and S&P on this one, although I respect FDIC’s efforts under Sheila Bair. The truth is that resolution of an international financial firm, connected globally to all these profit centers beyond the reach of US regulators, was always going to be next to impossible. And then there’s what S&P is talking about, the political economy. If you believe FDIC is going to be able to bully the rest of the government into disallowing financial support for a troubled firm, well, let’s say I’m dubious. Indeed, we have no idea if it will ever get to that point. Between Treasury and the Federal Reserve, a sick bank has plenty of options to get well.

Maybe banks will come through with “living wills,” steps that would be taken in the event of a resolution to dismantle the firm. The FDIC and the Fed haven’t created the rules for that yet. But I’m very dubious. So is Shahien Nasiripour:

“The next crisis will happen sooner rather than later,” said Anat Admati, a professor of finance and economics at the Stanford Graduate School of Business. “We’re not safer and there’s still a lot of systemic risks in large banks and in the financial sector overall.”

A central aim of the law, known as the Wall Street Reform and Consumer Protection Act, was to undercut the assumption that some institutions are so big that their potential failure could again force the government to rescue them, rather than allow their troubles to trigger another crisis. The very perception that the government stands ready to rescue the largest banks tends to be construed by the markets as a government insurance policy — one that encourages the executives at such institutions to take bigger risks.

But on the first anniversary of the act’s passage, the nation’s largest banks boast larger holdings than ever. Their political clout is on the rise, say experts, and the government regulators who are supposed to be looking out for the next wave of reckless speculation are starved of cash. Meanwhile, stalwart banking industry allies in Congress are seeking to crimp the authority of the regulators on multiple fronts.

“The structural problems are worse,” said Simon Johnson, a professor at the MIT Sloan School of Management and a former chief economist at the International Monetary Fund. “Their size, incentives — none of that has changed.”

Indeed, many banks are trying to exempt themselves from the rules of Dodd-Frank, according to a new report by Public Citizen. The banks are bigger than ever, and they’re using their lobbying clout to game the system in whatever way possible. Not to mention the fact that they still are not holding the kind of reserves to protect themselves in the event of a meltdown – just 11.3% of assets, as opposed to 10.4% five years ago, according to FDIC reports.

When there’s another crisis – and that’s not an if, but a when – we will know if the regulatory apparatus has the tools to protect the taxpayer from bailouts. I think there’s ample reason to be skeptical.

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David Dayen

David Dayen