If All Firms Can Fail, None Are 'Too Big to Fail'

One prime objective of last summer's financial regulation bill was to solve the "too big to fail" problem. During the financial crisis, regulators quickly realized that the failure of some big financial firms would have resulted in widespread economic devastation. These firms were deemed too big to fail, and bailouts and rescues resulted. Has the problem been solved or does it persist?

Over at the New York Times DealBook, Steven M. Davidoff argues that too big to fail doesn't just remain a problem -- it's been institutionalized. He notes that Congress chose not to simply break up the big firms so to make them smaller. Instead, he says, the legislation utilizes the new Financial Stability Oversight Council to regulate select firms that are too big to fail to ensure their safety and soundness, thus guaranteeing their survival going forward. He then worries about the consequences for firms being on this list. Here are some positive benefits he anticipates:

Too-big-to-fail banks may receive important competitive advantages from a lower cost of capital. Their cost to borrow money will be lower because they are perceived to receive an implicit government guarantee. They can also command greater access to regulators. And there are probably positive psychic effects of being labeled a big dog in the world financial economy. It may even secure the executives of these financial firms a coveted invitation to the yearly party at the World Economic Forum in Davos, Switzerland.

The first benefit he explains should not come to be, at least not according to the giant regulation bill. There is no implicit guarantee for firms on this list. Any perception that there is by creditors would be misguided. The legislation actually takes great care to forbid future rescues. This is clear through an understanding of the new non-bank resolution authority responsibility provided to the Federal Deposit Insurance Corporation.

The FDIC now has the power to take over and wind down any failing financial firm, no matter how large. As a result, there should no longer be any too big to fail institutions, at least in theory. It will likely be put to the test eventually, and we'll then see whether or not this new power works as advertised.

But won't the firms on the list have the sort of competitive advantage that Davidoff worries about? Again, this is will not occur according to the FDIC. It intends to operate its non-bank resolution authority in such a way that creditors of a giant failing firm will be treated just as they would be through a regular bankruptcy. The FDIC actually took measures to specifically ensure that creditors of firms it resolves through its new power do not obtain any special advantage. For example, even if it must provide creditors with too high a payout initially to ensure financial stability, the FDIC will claw back that excess in future years when all of the failing firm's assets have been liquidated. Any advantage provided to a creditor should be fleeting.

Davidoff may be right that these firms will have significant access to regulators and some "positive psychic effects." But any large firm in any industry already enjoys such benefits, so the financial regulation bill doesn't really set a new precedent there.

Instead, being formally labeled as systemically significant is intended to provide a competitive disadvantage to these firms to try to discourage institutions from growing too large. Davidoff mentions some of the negative measures that these firms will have to contend with:

But there will be detriments. Among other things, these institutions will have to hold more capital, be subject to more regulation and, in certain circumstances, can be broken up by the government.

So again, assuming you believe that the FDIC can really resolve a big financial firm like Goldman Sachs with its new power, then it and other firms on the list are actually worse off -- not better off. Not only can they fail like any other firm, but they will also be under more conservative capital requirements and more aggressive regulation. If everything works as planned, the too big to fail problem should be eliminated, and firms will also have a disincentive for growing to be gigantic.