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Too-Big-To-Fail, Four Years On

As fourth anniversary of the enactment of the Dodd Frank financial reform legislation passes, we are once again revisiting whether “too-big-to-fail” is in our past. The perennial discussion has become a distraction that gets in the way of the real issues of the financial system that persist to this day.

The real question, of course, is whether there is still a risk of having to bail out one or more financial institutions that are failing in order to avoid even broader harm to the public. Of course, this risk still exists. Governments are forced to intervene to counter severe financial panics. The financial system loses confidence in the viability of an institution causing it to run out of cash and this is transmitted to other institutions like a virus, a sort of financial ebola outbreak, that will ultimately cause a shutdown of money movements and credit. Panics have occurred throughout the history of capitalism and have had many causes. To claim that we have inoculated the economy for all possible manifestations of this disease is hubris of a high order.

But it is equal folly to think that Dodd-Frank did nothing to address the issue. The medical profession cannot cure ebola, but it has successfully developed practices that have increased survival by patients and slowed the spread of the disease. Financial reform has similar elements. It is better to use the anniversary of Dodd-Frank to consider how well we have confronted the problem of panics in the context of the modern financial system.

Dodd-Frank was never intended to alter the financial system fundamentally. Even Barney Frank says that Treasury and Congress created a regulatory structure that could get a majority of votes in a House and Senate deeply influenced by money from the banks. It was anything but revolutionary.

A centerpiece of Dodd-Frank is an effort to reduce the probability that the system will lose confidence in a big bank. More capital reserves were required. And a framework was established for winding up a failed institution in an orderly way, including a requirement that the banks continuously maintain a plan for their own windup in “living wills.” 

Some may say that in an extreme situation, these features would be implemented to save the day. But that assumes that the failsafe plan anticipates the underlying circumstances at the time of the threatened panic. It is hard to have faith that this would actually work given the history of the financial system and its propensity to evolve. It has even been argued that bolstering confidence in financial institutions will ultimately delay the panic causing it to be even worse when it occurs.

Instead of debating foolproof remedies, we should view the financial system as more like a pile of sand. As one adds more sand, the pile stays together because the grains have complex shapes. But eventually, there will be an avalanche. Scientists tell us that the complexity of such systems means that we cannot predict when the avalanche will occur or its intensity. But we do know that each addition of sand without an avalanche increases the consequences of the inevitable event exponentially. In such systems (which include snow banks and earthquake faults), the only way that consequences are reduced is if lesser events are induced (that is why the ski patrol induces a small avalanche) or if the system becomes less complex so that it does not hold together for as long.

The financial system remains too complex, with derivative and securities portfolios even bigger than before 2008. It is still extremely concentrated in a few large institutions. These megabanks are so large because the system is so complex. They are like big sand piles whose avalanche was abated by the bail out in 2008. We can break up the banks. But even this will not eliminate the core problem of an interconnected complex system that will simply evolve into different forms of sand piles.

Which brings us to the real concern on this anniversary. It is not that the too-big-to-fail remedies of capital and bank failure resolution procedures should be abandoned. They are simply inadequate on their own (and may even make things worse) if the complexity of the financial system is not dramatically reduced. The Dodd-Frank Act did some things to reduce complexity, but not nearly enough. And the financial sector’s political power has increased and many of these provisions have been severely watered down during the act’s implementation.

Just how much the consequences of too-big-to-fail have been mitigated by financial reform remains an elusive concept. Like the scientists, we simply do not know when the avalanche will occur or how severe it will be, but history tells us it will happen. If it is extremely forceful, the existing provisions are likely to be overwhelmed and the government will face a bail out.  It will be a shame if future history books record that the political system was so dominated by Wall Street that it did not protect the public from a panic as bad, or even worse than, the crash of 2008.