Why Ben Bernanke Will Regret Declaring Mission Accomplished on "Too Big to Fail"

Last Updated Sep 3, 2010 9:04 AM EDT

Here's a simple test for determining if the era of "too big to fail" is over, as Federal Reserve Chairman Ben Bernanke and FDIC chief Sheila Bair said it is in their appearance today before the Financial Crisis Inquiry Commission. Ask yourself -- in your role as businesspeople, taxpayers, voters, investors, borrowers, parents -- whether you expect the U.S. government to bail out the nation's largest financial firms the next time calamity strikes.

If the answer is yes, then TBTF lives. After all, that's what this unofficial designation is all about: a market perception, shaped by an understanding of economic and political realities, that the feds must guarantee the existence of certain institutions because of these companies' importance in the financial system.

It's the central question of the financial crisis. Because while the meltdown had many causes -- from fraudulent mortgage lending, fictitious credit ratings and dangerous financial "innovation" to hapless regulation and political corruption -- it couldn't have happened without the super-sizing in recent years of a handful of companies. Firms, it's worth remembering, that are getting bigger.

If the issue of what to do about these titans remains the same, so does the nature of the proposed solutions. The debate today, as it was in 2008, remains not whether government will intervene in the financial markets when the next meteor strikes, but how. Will we again rescue big banks, allowing taxpayers to absorb their losses in the name of preventing financial Armageddon; or will we emulate the FDIC in how it deals with small failing banks and also nationalize larger firms?

If Bernanke and Bair are to be believed (not to mention President Obama, Congress and the banking industry), then the Dodd-Frank financial reform law gives government watchdogs the means to avert disaster. Under this thinking, regulators now have the authority to seize big banks, which also must implement "living wills" to ensure their orderly resolution. The Fed is barred from lending directly to institutions, which in theory should curb their appetite for risk. A council of regulators also is taking shape that will help deal with emerging threats to the financial system, reducing the chance of contagion.

As Bair told the Financial Crisis panel in her prepared testimony:
The new regulatory tools made available by the Dodd-Frank Act provide a roadmap for maintaining financial stability in the face of potential systemic risks posed by large, complex, interconnected financial institutions and financial activities. They force large, complex financial firms to take primary responsibility for managing the risks that they pose to the financial system... In the less likely event of a future financial crisis, these tools provide an orderly and transparent means for winding down systemically important financial companies.
Regrettably, I doubt much of this is true. And the part that is looks impractical and politically unfeasible. Because while we do now have a roadmap for resolving TBTF financial firms, there are a number of reasons to think regulators won't follow it:
  • Speculation is alive and well on Wall Street. The financial incentives for bankers and traders to act recklessly persist. Although there may now be an element of doubt about how far the government will go to save TBTF firms, that risk is an abstraction compared with the vast, immediate financial rewards of betting with other people's money. And despite Dodd-Frank's efforts to constrain risk-taking by Wall Street, big banks are already finding ways to skirt the law and develop new products less subject to regulation.
  • Whatever their statutory powers, regulators remain handcuffed. As much as Bernanke and Bair may want to believe that they, and Washington, will allow regulators to wind down big banks, those powers have never been used. No one can be sure whether it will work. If the financial system is teetering on the edge, enormous pressure will be applied -- by lawmakers, banks, investors, foreign governments, even the regulatory establishment itself -- to stick with known solutions. That means bailouts.
  • Disposing of TBTF firms is dauntingly complex. Although Bair's description of "resolution authority" sounds straightforward, it's anything but. Seizing a systemically risky bank will require consensus among all the financial regulatory agencies, the U.S. Treasury and the White House. Even foreign governments will have to be consulted, given TBTF firms' global operations, while regulators must be sure that their decision will stand up in court. If the next crisis moves as swiftly as the last one, securing that consensus quickly will be enormously difficult.
  • TBTF firms are bigger and more interconnected than ever. The collapse of Bear Stearns, Lehman Brothers and other big financial firms has made the surviving banks even more central to the U.S. economy. Financial industry consolidation is also likely to intensify in coming years, as the winners buy the losers. Meanwhile, Dodd-Frank does little to reduce the danger that the failure of a large financial institution could topple other firms.
  • Political will remains weak to challenge TBTF firms. Although regulators have more options for dealing with troubled financial companies, the political class remains beholden to these firms. That's why during the financial reform fight (all) Republicans and (most) Democrats alike summarily rejected proposals to break up big banks. Over time, and as memory of a given crisis fades, regulators also have a tendency to be "captured" by the industry they regulate. That, too, saps the institutional will to challenge big firms.
Returning to our litmus test above, to declare an end to TBTF requires an enormous suspension of disbelief regarding the forces acting on our financial system. And finally, it implies an investment of trust in our bankers, regulators and lawmakers that none of these parties, in recent years, have earned.

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  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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