What Does "Too Big to Fail" Mean Anymore?

Simon Johnson, a former IMF economist, has a piece on his Baseline Scenario blog today about former Treasury Secretary Hank Paulson's testimony to Congress yesterday, which he ties into the larger story of how we let a handful of banks control such a formidable swath of our financial system. Even as we collectively intoned the lesson Too Big to Fail is Bad, Too Big to Fail is Bad, we're seen Countrywide Financial, the mortgage lending giant, and Merrill Lynch swallowed by Bank of America, while JP MorganChase absorbed Bear Sterns and Washington Mutual. And we didn't just allow this to happen. At times, we forced it to happen.

As a result, we've avoided government nationalization at the expense of basically allowing JP Morgan and Bank of America to nationalize the banks for us.

Why is that important? Because it puts the future of bank regulation in an awkward spot: 1) We're allowed these BofA and JPMorgan to get Way Too Big to Fail; 2) Now that both banks are reporting quarterly profits, they'll be untethered to government assistance for the conceivable future; and yet 3) These giants, and Goldman Sachs, know that if profits do slump in the case of a double-dip recession, the government has to leap in because they are, definitionally, Way Too Big to Fail.

The solution to this conundrum, as outlined by Obama's Financial Regulatory Reform plan in June, is to hold huge banks to strict capital standards and charge the Federal Reserve with keeping a watchful eye on their leveraging. The administration allegedly hopes that this will convince firms to downsize or at least mitigate their risk-taking, to avoid another September 2008.

But, as Tim Fernholz notes, dampening risk-taking is another way of saying dampening profits. Even as they emerge from a recession, we will be asking banks to sacrifice revenue to protect them from themselves. Our TBTF banking system will come to resemble that favorite metaphor of prudent restraint from Fareed Zakaria, in which the noble Ulysses asks his men to bind him to the shipmast to keep him from heeding the Sirens' call to run his boat into the rocky cliffs.

This brings me back to the Paulson testimony yesterday, in which he admitted to threatening BofA CEO Ken Lewis not to back out of the Merrill merger. Now that BofA is way TBTF, will it descend on a reformist-minded Washington and pursuasively argue that the government is essentially punishing Bank of America for listening to Hank Paulson? The animating philosophy behind the government's bank plan has been: Save the big banks, by any means necessasry. Is anybody in the government really prepared to look Wall Street in the face and say: We need you to make less money?