Did Dodd-Frank end Too Big to Fail? It depends what you mean by ‘end.’

December 6, 2013
Treasury Secretary Jack Lew thinks real progress has been made on Too Big to Fail. Is he right? (Andrew Harrer/Bloomberg)
Treasury Secretary Jack Lew thinks real progress has been made on Too Big to Fail. Is he right? (Andrew Harrer/Bloomberg)

It's not quite a victory lap, but Treasury Secretary Jack Lew is arguing that the battle against too-big-to-fail financial institutions is largely won. Yes, there remain enormous banks with multitrillion-dollar balance sheets and operations in all corners of the financial world. But, Lew said in a speech Thursday, the reforms implemented through the Dodd-Frank Act are making it pretty much unthinkable that one of these institutions could fail in a way that brings on a government bailout or leads to a catastrophic economic downturn.

"Put simply, the reforms we are putting in place raise the cost for a bank to be large, requiring firms to internalize their risks, and together, with resolution authority and living wills, make clear that shareholders, creditors, and executive s— not taxpayers — will be responsible if a large financial institution fails," Lew said at the Pew Charitable Trusts.

"Earlier this year, I said if we could not with a straight face say we ended 'too big to fail,' we would have to look at other options. Based on the totality of reforms we are putting in place, I believe we will meet that test. But, to be clear, there is no precise point at which you can prove with certainty that we have done enough.  If, in the future, we need to take further action, we will not hesitate."

There are quite a few caveats in there. If the question is "Has Too Big to Fail been solved?" then Lew's answer is not a simple, "Yes," but more like, "I think so, but we won't know for sure until one of these firms runs into trouble, and in the meantime we need to be constantly thinking of how to make our regulations better."

But what is Lew referring to, and does he have a case?

Lew's approach -- and that of other leading U.S. regulators, for that matte r-- has not been to start with some baseline assumption about what the proper size and complexion of the U.S. financial industry ought to be. Rather, he (and counterparts at the Federal Reserve and beyond) has tended to focus on narrower questions, demanding that firms that are large and complex enough to endanger the entire economy pay a price for that privilege: higher capital requirements, more stringent stress testing of how they might fare in a downturn, more detailed plans required of how they would be wound down in the event of a failure, more regulators scrutinizing different aspects of their business.

Then, the companies themselves have to make a series of decisions. To what degree is their size an advantage (you get economies of scale, after all, and geographical reach and the whatever synergies that can come from offering a wide range of financial services) and to what degree is size a disadvantage (the too-big-to-manage problem, plus all those regulatory headaches).

Over time, management teams and boards of the big banks will have to weigh those against each other, and if the costs of size exceed the benefits, they will carry on (that's what JPMorgan Chase seems to be doing, adding 3,000 compliance workers and spending an extra $1 billion on technological controls). If they decide that it's just not worth it, they will shrink (that's what Swiss bank UBS did last year when it cut 10,000 jobs, and what Bank of America is doing in getting out of the mortgage business).

Over his nine months as Treasury secretary, Lew has spent a considerable amount of time knocking heads with the panoply of often-squabbling financial regulators who have to come together to actually carry out the details of the Dodd-Frank financial reforms. While he doesn't have any direct control over, for example, the details of the "Volcker Rule" regulations that seek to prohibit banks from engaging in speculation, Lew has used his soft power to push disparate agencies to work together to arrive at rules expected to be approved next week.

Whether that rule, and the other steps that the Obama administration and regulators have taken to try to strengthen the financial system over the last three years, will be enough to stop bank failures from being catastrophic for the economy boils down to this question:

Was the problem that led to the 2008 crisis one of just poor regulation? Of insufficient capital requirements and excessively lax oversight, which can be fixed by doing all those things better? Or was the problem in 2008 more fundamental? Is the mere existence of multitrillion-dollar financial behemoths, with their political connections, lobbying budgets, and inherent risk to the global economy the problem.

If you believe the first case, then Lew and the Obama administration have come a long way, and we really do have a more resilient system than we did before. If you think it's the latter, then God help us all.

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Neil Irwin · December 6, 2013