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The Persistence of Too Big to Fail

Anyone who looks at the rationale offered for the bailouts of 2008—that certain financial institutions were “too big to fail” and therefore had to be rescued at taxpayer expense, no matter how incompetently run they were or how big the risks they took—has to be puzzled at the structure of the financial services industry in 2011. Surely, if the problem was that these institutions were “too big to fail,” the solution cannot be to make these institutions even bigger. Yet that is exactly what has resulted from the bailouts, the misguided policies adopted by panicked regulators, and the implicit subsidies that the Dodd-Frank Act offers to behemoth financial institutions to stay as large as they possibly can.

When the financial crisis struck the nation in 2008, officials pumped hundreds of billions of dollars into the country’s biggest financial institutions because these officials feared that their failure would crash the entire financial system. But in 2011, the country’s financial system is far more concentrated and less competitive than it has ever been. The five largest financial institutions control more than half of the industry’s assets, which is equal to almost 60% of GDP. The largest 20 institutions control 80% of the industry’s assets, which amounts to about 86% of GDP. Common sense says that “if they are too big to fail, make them smaller.” No one can say with a straight face “if they are too big to fail, make them even bigger.” Yet that is exactly what has resulted from misguided government policies and the Dodd-Frank Act.

The proponents of the Dodd-Frank Act will tell you that the Act bans bailouts. That government will never again come to the rescue of a large financial firm that finds itself in trouble. That taxpayers will never again be on the hook for paying off the creditors of an AIG or a Bear Stearns. There’s just one small problem with that assertion: no one believes it.

Not the creditors of these giant firms: they continue to lend to the too-big-to-fail firms—and they continue to lend more cheaply to these giant firms than they do smaller, less risky banks—because they continue to believe that when push comes to shove, government officials will intervene, no matter how much they say they hate bailouts and want to protect the taxpayer.

Not the credit rating agencies: although the credit rating agencies make noises about possibly downgrading the too big-to-fail firms in light of the Dodd-Frank Act, those noises are not a downgrade. Moody’s, for example, has said that it will not likely withdraw its assumption that government will support a too-big-to-fail firm from its ratings for these firms. And Standard & Poor’s has made it quite clear: they don’t believe that the Dodd-Frank Act ends too-big-to-fail. As they explained, the government’s “when in doubt, bail it out” policy trumps whatever good intentions the drafters of the Act may have had in mind.

On July 12, S&P wrote that “We believe that under certain circumstances and with selected systemically important financial institutions, future extraordinary government support is still possible.”

To put it slightly differently, S&P has said that government still has the motive and the means to commit another bailout; the only thing that’s missing is opportunity, and that will come soon enough.

And a higher rating makes it cheaper for a too-big-to-fail firm to borrow, which makes it even bigger. We’ve all seen this picture before. The difference is that the proponents of the Dodd-Frank Act think that it will end differently this time around. The American people know better.

But the most frightening fact of all: not even the Secretary of the Treasury, Timothy Geithner, believes that the Dodd-Frank Act ended “too big to fail.” When asked about the multiple rescues of Citigroup and whether the Dodd-Frank Act ended “too big to fail” by the Special Inspector General for the Troubled Asset Relief Program, Secretary Geithner said out loud what everyone already knows to be the truth: “In the future we may have to do exceptional things again if we face a shock that large.”

But the Dodd-Frank Act was supposed to save government officials from doing “exceptional things”; that is the reason for its existence. If the Dodd-Frank Act means that “in the future we may have to do exceptional things,” then the Dodd-Frank Act cannot credibly be said to have ended “too big to fail.”

You Say You Want a Resolution?

But the proponents of the Dodd-Frank Act point to Title II of the Act—the “resolution authority” that gives the Federal Deposit Insurance Corporation the ability and the wherewithal to wind down in an orderly way a “too big to fail” firm. The reasoning that the supporters of the Dodd-Frank Act offer us is this: the FDIC can wind down a small bank with no problem at all; therefore, the FDIC can wind down a behemoth, multinational, complex financial institution, no problem at all. It doesn’t matter how big, how complex, how international the firm is: the FDIC can “resolve” it. And this “resolution” can be done without costing the taxpayers a single dime. After all—the Dodd-Frank Act banned bailouts.

But Dodd-Frank’s “resolution authority” has a couple of problems that its supporters would rather you did not notice. The first is that it simply won’t work for the largest, most complex financial institutions. Remember how the supporters of the “resolution authority” told you not to worry, because this was just like “resolving” a small bank? Let’s take that claim seriously. This is how the FDIC resolves a “small bank,” according to a 2009 article in The Economist magazine:

If the FDIC agents had tear gas rather than briefcases, we’d understand them to be a SWAT team. Eighty of them flew into Clark County, checked into hotels under assumed names, gave false reasons for their visit, and around 6 P.M. on that Friday, walked in and assumed control of the bank. By all accounts—including those of the employees at the Bank of Clark County—the FDIC was almost startlingly competent, professional, and sophisticated. Even the workers who were seeing their labor dismantled and their jobs destroyed sound impressed by the cool efficiency of the Feds.

That sounds pretty good. In on Friday, out by Monday. There’s just one small problem:

The Bank of Clark County had 100 employees and assets of $440 million which, if you’re not used to bank numbers, is a really small bank. But it took 80 FDIC agents, 50 bank employees, and 100 employees [from the neighboring bank that assumed control] working round-the-clock for three days to take it over and have it reopen for business.

Most of the largest banks in trouble right now—Citibank, Bank of America—are about 6,000 times the size of the Bank of Clark County, not to mention much, much more complicated.

For those who don’t have calculators handy 80 multiplied by 6,000 is 480,000. On the bright side, that’s one hell of a stimulus opportunity.30

But let’s leave aside, for the moment, the “you and whose army” problem that the “resolution authority” poses. Let’s look at the “you and whose money” problem. That one is easy to answer: whose money? The American taxpayers’, that’s whose.

Those who believe in the “resolution authority” are fond of telling you that it won’t cost you a dime: the Dodd-Frank Act bans bailouts, and it mandates that no taxpayer funds be used in resolving a financial institution.

But remember Secretary Geithner and the “exceptional things” that “we” may have to do? That “we” means regulators and government officials (they decide) and you (more specifically, your dollars). Here is how it works.


Pretty funny test.
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