‘Too Big to Fail’ May Still Exist Despite Democrats’ Regulations

By Matt Cover | June 15, 2011 | 5:10 AM EDT

Washington (CNSNews.com) – Christy Romero, the acting Special Inspector General for the TARP bank bailout program, told the House Financial Services Committee on Tuesday that the Dodd-Frank financial regulatory law may not end the “too big to fail” policy and the moral hazard surrounding it.

Testifying before the House Financial Services Committee’s Financial Institutions and Consumer Credit Subcommittee, Romero said that as far as the market is concerned, too big to fail is not dead.

“The mere enactment of the Dodd-Frank act did not end the concept of ‘too big to fail’ in the market’s eyes,” Romero said. “So long as the financial institutions, counterparties, and ratings agencies believe there will be future bailouts, competitive advantages associated with ‘too big to fail’ institutions will almost certainly persist.”

Romero noted that shortly after the passage of Dodd-Frank – which gave the Federal Deposit Insurance Corporation (FDIC) the power to wind-down large financial institutions – two major credit-rating agencies announced they would permanently incorporate the likelihood of government bailouts into their ratings of major bank bonds.

In other words, the ratings agencies would assume that the government would still bail out big banks if they fail, making their debt more secure because it carries this implicit federal guarantee.

Romero said because the markets assume that the government will continue to bail out large financial firms, the moral hazard caused by the original 2008 bailouts would continue.

“As long as the markets perceive future bailouts, market discipline will be reduced as creditors, investors, and counterparties have less incentive to monitor those institutions they believe the government will save in the future.”

Romero noted that the Dodd-Frank law did in fact make 2008-style bailouts illegal, preventing the government from simply giving money to major financial firms to keep them from going bankrupt. However, she said, merely enacting the law did not end “too big to fail” because rules are only as strong as the people enforcing them.

“In order to end ‘too big to fail,’ the regulators must take effective action now, using the tools given to them under Dodd-Frank for the markets to be convinced that the government will not intervene again.

“Rules, however, are only as effective as their application. In order to convince markets, promises of the regulators to end ‘too big to fail’ must be matched with actions that signal with certainty that the government will not make future bailouts.”

Romero also noted that additional regulations Dodd-Frank imposed on what it calls Systemically Important Financial Institutions (SIFI) have yet to be written.

Rules such as increased capital requirements, the contents of the “living will” liquidation plans an SIFI must file with the government, and whether or not the government will require an SIFI to restructure its business to become less systemically intertwined all have yet to be drafted, meaning that no firm knows whether the government will hold the line against future bailouts or not.

“These actions rely on the courage of the regulators to protect our nation’s broader financial system against any institution whose demise could potentially trigger another financial crisis,” Romero said.

Rep. Barney Frank (D-Mass.), the ranking member of the Financial Services committee and the co-author of the Dodd-Frank bill, countered that these as-yet-unwritten regulations are designed to prevent major bank failures in the first place. Despite Romero’s skepticism, he said his law makes bailouts illegal.

“The bill deals with the failure of large institutions in two ways -- first of all by significantly increasing the regulators’ ability to stop this from happening, or make it less likely,” Frank said.

“Secondly, in terms of bailouts, I want to mention one of the major things that the law does that ends the bailouts. The largest single bailout for an institution was of AIG. AIG was bailed out by the Federal Reserve under statutory authority,” Frank continued. “We abolished it. That’s one big example of a bailout authority that no longer exists.”