Why ‘Too Big to Fail’ is a psychological construct

When it comes to Wall Street, liberals and conservatives can agree on at least one thing: The government should avoid bailing out big banks on the taxpayers’ dime. Dodd-Frank was supposed to make that less likely to happen. But it’s uncertain whether that will actually happen, as the new regulation has no explicit prohibition on bailouts.
(Richard Drew - AP)

The Dallas Federal Reserve now counts itself among the skeptics, arguing in a new report that Too Big to Fail remains “entrenched” in Dodd Frank, even though the law takes away some of the big banks’ advantages. And as long as people believe that big banks will ultimately be bailed out, the Dallas Fed concludes, they’ll continue to benefit from that implicit government insurance.

Big banks are subject to a whole slew of new regulations that are meant to stabilize the system — thus making the meltdowns that require bailouts less likely. The problem is, banking regulators might not be able or willing to intervene forcefully enough to close big banks if they’re going down and threaten the rest of the financial system. For example, big banks are required to submit “living wills” that explain how they’d unwind in an orderly fashion — e.g., avoiding a taxpayer bailout — but it’s unclear how bank regulators will force them to restructure if they determine that their plans are inadequate.

“The pretense of toughness on TBTF sounds the right note for the aftermath of the financial crisis,” the Dallas Fed writes in a new paper. “But it doesn’t give the watchdog FSOC and the Treasury secretary the foresight and the backbone to end TBTF by closing and liquidating a large financial institution in a manner consistent with Chapter 7 of the U.S. Bankruptcy Code.”

Regulators and legislators still have the ability to reject bailouts, and the way they ultimately enforce Dodd-Frank could make the rules stronger than they may currently appear. But, the paper points out, as long as the financial industry believes that the government would ultimately bail out big banks, the banks will still have funding advantages over “small enough to fail” institutions — and could continue to grow larger and riskier.

“Words on paper only go so far. What matters more is whether bankers and their creditors actually believe Dodd–Frank puts the government out of the financial bailout business. If so, both groups will practice more prudent behavior,” the Dallas Fed concludes.

To tackle the problem more effectively, the Dallas Fed wants the government to break up bigger banks into smaller pieces, as Simon Johnson, James Kwak and Jon Huntsman have all proposed. Republicans such as Rep. Paul Ryan also believe Too Big to Fail hasn’t been eliminated, but his solution would be to repeal the new rules to break up big banks, which some conservatives argue is a hidden bailout.