New rules that intend to end "too big to fail" and stricter capital requirements for large banks may help competition

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Although some in Washington proclaim that the era of "too big to fail" is over, some market observers aren't so sure. Mergers that occurred during the financial crisis created even bigger, more systemically risky institutions through the unions of already giant institutions. If regulators haven't actually figured out how to allow these enormous banks collapse, then that's a problem for economic stability. But the size of these institutions also creates a problem for competitiveness: being large has its advantages. However, some of those benefits may soon disappear.

Moody's Dilemma

When it became clear that the U.S. government would not allow another big bank to fail, the ratings agencies took this advantage into consideration when evaluating the institutions' stability. But the firm is now studying whether or not that protection remains intact, given the government's recent regulatory efforts to curb bailouts. Tim Carney from The Washington Examiner reports:

Last week, the ratings agency announced a review of whether these bailout assumptions still apply after passage of the Dodd-Frank financial regulation bill. The Moody's review will be the truest test yet of President Obama's promise that the legislation -- derided by Republicans as a bailout bill -- can end the "Too Big To Fail" dynamic that has encouraged financial risk taking and given these banks an unfair advantage.

The implicit government guarantee these banks enjoy is a subsidy. The "five notches of uplift from government support assumptions" that Moody's gives to Bank of America translate into real profits for Bank of America. Without a presumed bailout, Bank of America's senior debt would be rated Baa3, just barely on the right side of the "Investment Grade"/"Speculative Grade" boundary. The presumed "government support" raises the bank's debt rating to A2, which is "very low credit risk." Even Wimpy from "Popeye" would be a "very low credit risk" if you could count on Ben Bernanke and Tim Geithner to pay for his hamburger.

The key to big banks' supposed ability to fail lies in the hands of the non-bank resolution authority, the new mechanism owned by the Federal Deposit Insurance Corporation to wind down large financial firms that collapse. If Moody's finds that this new power will work effectively, then it will downgrade some big banks, effectively removing their funding advantage. If it decides that a crisis would still result in government rescues, then those ratings -- and the benefit they provide -- will remain intact.

Ultimately, this will come down to whether Moody's believes that the market has sufficient discipline to hold these institutions accountable for their choices. In May, I spoke with Michael Krimminger, FDIC General Counsel, about the problem that would still persist if several big banks failed at once: you can't wind down the entire industry. He explained that once investors see an institution resolved by the new process, they won't permit banks to take risk so lightly. The new authority will work, he says, because it will introduce market discipline.

This, of course, assumes that prior to 2008, investors believed that the big banks were too big to fail and would be rescued by the government, which would explain the lack of market discipline. It will be interesting to see if Moody's finds this explanation compelling.

Thicker Capital Cushions

Whether Moody's decides that big banks exist without government backing or not, regulators are taking others steps that would effectively level the playing field. Reports indicate that Federal Reserve officials may support global capital standards that would subject big banks to a capital surcharge of between 3% and 7%. So even if banks did derive some debt-cost advantage due to assumed government support, their capital costs will rise. This could minimize the prior benefit and help to level the playing field.

But it may also result in big banks becoming almost utility-like. If these institutions are so burdensomely regulated that they have to retain an amount of capital that will almost certainly insulate them from failure, then they are essentially being forced to take less risk. All that capital they have to tie up means they can't borrow as much and can expect smaller returns to capital. This will provide smaller institutions with the ability to get into the game in a way they couldn't in the past.

A More Competitive Landscape

Assuming that either Moody's decides to reduce the ratings of these big banks due to the withdrawal of government support or the institutions' capital requirements rise considerably, the financial sector will look quite different in the future. Although big banks may continue to have certain advantages, like returns to scale and market dominance, their low funding costs and their ability to lever themselves to the hilt might vanish. This certainly won't make the financial industry a perfect market, but it should make it more competitive.

Image Credit: REUTERS/Lucas Jackson

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