“Too big to fail” business model still alive and kicking

The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law nearly two years ago. It was supposed to protect us from another financial meltdown like the one in 2008-09 that almost tipped the world economy into a deep depression.

As we approach its anniversary on July 21, I’ll devote three Sunday columns to Dodd-Frank and where it stands today. Next week, I’ll look into whether or not implementation of the law thus far prevents or at least discourages our major financial institutions from taking inappropriate risks with tax-payer insured assets. The week after, I’ll explore the progress, or lack of it, that regulatory agencies are making in writing new regulations required by Dodd-Frank.

Today, let’s look at the impact of the law on one key issue – making sure that none of our financial institutions will in the future have to be bailed out because they are “too big to fail.” A lot of the provisions in Dodd-Frank were hotly debated two years ago, but there was nearly unanimous agreement in Congress that we had to make sure taxpayers would never again have to bail out a bank.

Are we still on the hook? Just before the financial crisis, the largest banks’ assets amounted to 43 percent of the U.S. economy. (To put that in historical perspective, in 1984 it was 9 percent.) At the end of 2011, the five largest banks’ assets had increased to 56 percent. While some of that increase in assets was due to internal growth, most of it was caused by mergers forced on them to avoid a collapse of the system. Merrill Lynch and Countrywide were merged into Bank of America, Washington Mutual and Bear Stearns became part of JP Morgan Chase, Wachovia joined Wells Fargo, and so on.

Obviously, the big have gotten bigger. If any of them got into trouble, would the government again have to come to their rescue? I don’t know anyone who would bet against that. Certainly the worldwide bond markets are convinced it would happen. A recent study by Bloomberg News, using International Monetary Fund data, reveals that the big five banks – JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, and Goldman Sachs – borrow money on the open market at a rate that is 0.8 percent lower than the rate paid by smaller banks. Small change? Think again. According to Bloomberg, in the case of JP Morgan Chase that favorable “too big to fail” rate amounts to a $14 billion a year government subsidy – about 77 percent of its net income over the past year.

Being too big to fail gives JP Morgan Chase and the other four megabanks other competitive advantages as well. Their credit ratings are based on S&P’s and Moody’s confidence in taxpayer bailouts. And, given a choice, if you were a big depositor, wouldn’t you use a bank you know will be bailed out?

Jamie Dimon may scream it isn’t so, but the bottom line is that his bank’s business model is in large measure dependent on being too big to fail.

Dodd-Frank gives the Federal Reserve and the FDIC resolution authority over a failing bank. But there is nothing in place that resolves problems across national borders. The comparatively simple Lehman Brothers bankruptcy has still not been resolved after three years, mainly due to problems with major creditors in the United Kingdom. The “living wills” Dodd-Frank required the major banks to write, spelling out how they would be wound down in a crisis, were released last week. Most independent observers have panned them as hypothetical scenarios that would be of little use in the real world. For one thing, each of the wills depends on that bank’s ability to sell assets in an orderly manner to another large financial institution. The odds of that happening in an actual crisis are slim; given how interconnected they are, if one megabank is in trouble, the probability is they will all be in the same boat. “Orderly” is not what happens in a meltdown.

Are our largest banks still too big to fail? Of course they are. Will Dodd-Frank fix that? No. That’s why Sen. Sherrod Brown recently reintroduced the amendment he and I wrote before Dodd-Frank was passed. Brown-Kaufman placed sensible size limits on banks and restricted any one bank’s assets to 10 percent of U.S. GDP. It failed by a 66-33 vote in 2010, but recent events have only made our case stronger. Until something like it becomes law, we are all at risk of another too-big-to-fail financial catastrophe.

Originally published 7 July 2012 on delawareonline.com