The most striking lessons from the financial crisis and its aftermath already appear either to have been forgotten or to have never been learned. The American financial system can still be brought to its knees by the poor decisions of a small group of executives.
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Two of the most striking lessons from the financial crisis and its aftermath -- that the continued existence of financial institutions deemed "too big to fail" seriously threatens the nation's economy and fiscal well-being, and that our financial regulators have a limited ability to oversee those institutions -- appear either to have been forgotten or to have never been learned.

The financial crisis demonstrated that the stability of the country's financial system is vulnerable to the bad decisions of just a handful of executives at the small number of financial institutions that have been effectively guaranteed against failure by the United States government. The continued existence of such institutions, and more particularly the market distortions that accompany the perception of government guarantees, remain, in the words of Kansas City Federal Reserve Bank President Thomas Hoenig, "the greatest risk to the U.S. economy."

As has now been well documented, the out-of-control risk accumulation by "too big to fail" firms -- now dubbed "Systemically Important Financial Institutions" or SIFIs -- helped precipitate the financial crisis and necessitate the government's extraordinary multi-trillion dollar effort to prevent financial Armageddon. One part of that response involved the government sponsoring, supporting, subsidizing -- and, when deemed necessary, threatening -- the largest financial institutions to swallow up their struggling counterparts. Indeed, then-President of the New York Federal Reserve Bank and current-Treasury Secretary Timothy Geithner so zealously sought to serve as matchmaker between these institutions that several of the financial institutions' chief executive officers nicknamed him "eHarmony," after the on-line dating service.

Beginning with the Federal Reserve's support of JP Morgan Chase's acquisition of Bear Stearns and continuing through Treasury's use of Troubled Asset Relief Program (TARP) funds (as well as explicit threats to management) to ensure that Bank of America would complete its merger with Merrill Lynch, the government's response to the crisis made the five largest U.S. financial institutions 20% larger, and therefore more dangerous, than they were before the crisis. This historic concentration could have been far higher, of course, if other mergers advocated by the New York Federal Reserve Bank had occurred -- such as between Citigroup and Goldman Sachs (currently the 3rd and 5th largest bank holding companies in the United States) or JP Morgan Chase and Morgan Stanley (ranked 2nd and 6th).

In addition to materially increasing the size of the largest financial institutions, the government's response to the crisis through TARP and other efforts made explicit what many had long suspected -- that certain institutions had amassed so much economic power, both individually and collectively, that the government simply could not allow them to fail. Further, the manner in which the bailouts were conducted served to exacerbate market distortions by protecting against loss other market participants who, in a normally-functioning market without government guarantees, would have imposed the necessary market discipline to compel the largest institutions to contain their excessive accumulation of risk. For example, the bailed-out institutions' creditors and counterparties largely suffered no losses, reinforcing their belief that they too would be protected in a crisis. Similarly, the executives who were responsible for leading their firms into the crisis retained their outsized pre-crisis risk-enhanced payouts (and often their jobs); and shareholders were largely spared the total loss that they would have suffered absent government intervention. In other words, the bailouts largely rewarded stakeholders who relied on the implicit guarantee of a government bailout, and punished only those who had to pay for it -- the taxpayers.

That the country's financial system was (and still can be) brought to its knees by the poor decisions of a small group of financial institution executives is an unconscionable policy failure. The Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) was enacted to address both that failure and the exacerbation of moral hazard that accompanied the bailouts, making the broad promise to once and for all "end 'too big to fail'" and the associated "taxpayer funded bailouts."

Today, it is obvious that this effort is failing, at least so far. The market continues to bestow upon the largest financial institutions the substantial benefits that flow from an implicit government guarantee. Indeed, the credit ratings agencies remain committed to granting the largest institutions enhanced credit ratings based on the assumption that they will be bailed out once again, and by some reports, those institutions' funding advantage has actually increased since Dodd-Frank's passage. As a result, one of the significant causes of the 2008 financial crisis -- the market distortions flowing from the perception that the government serves as Wall Street's backstop -- has in many ways only gotten worse. With this perception comes the perverse incentives that encourage executives at these institutions to accumulate more and more risk, both to realize short-term payouts for themselves and to compete with their risk-accumulating, maximum-return-on-equity-seeking SIFI brethren. As a result, the continued failure to take the dramatic steps necessary to alter the market's perception that bailouts will once again be necessary will inevitably encourage behavior that will make another crisis (and the need for further bailouts) far more likely.

While DFA has not convinced the market that its goal of ending bailouts has been met, it did provide regulators with powerful tools, which if used properly and aggressively, could mitigate systemic risk and the need for bailout. For example, DFA directs regulators to use its "living will" and resolution provisions to, directly or indirectly, simplify, shrink, ring-fence or materially change the capital structure of SIFIs before the next crisis strikes in order to reduce their systemic risk.

A fundamental flaw of DFA, however, is its failure to recognize one of the most important lessons of the financial crisis: that regulators are fallible and often lack the political will and capital to successfully regulate systemic risk. Simply giving the regulators a host of powerful tools does not necessarily mean that they will know when and how to use them and have the wisdom to use them appropriately (DFA did create the Office of Financial Research which may, over time, assist regulators in finding pockets of systemic risk in the financial system). More importantly, as recent history has shown, no legislation can confer upon the regulators the fortitude to withstand the intense pressures that will be exerted on them should they attempt to seriously challenge the "too big to fail" business model. After all, these are the exact same regulators whose capture, incompetence, and inability to resist the forces of Wall Street were described by the Financial Crisis Inquiry Commission as "widespread failures" that "proved devastating" to the financial system.

Furthermore, even if the regulators are up to the task, under DFA, the ultimate responsibility for addressing the problems arising out of "too big to fail" institutions rests largely on the shoulders of the Secretary of the Treasury, whom DFA anoints as the Chairman of the newly-created Financial Stability Oversight Council (FSOC). In that role, the Treasury Secretary has broad responsibility for DFA's implementation, including final decision-making authority over forcing a SIFI into orderly liquidation, and overseeing the required two-thirds vote of FSOC's members to compel material changes in the size and structure of SIFIs to make them less systemically dangerous. Therefore, even assuming a level of competence and resistance to capture that has not been previously demonstrated by the independent regulatory agencies, the ultimate decision will rest with a political appointee who serves the political interests of the governing administration. Given the economic, political, and lobbying power of the largest financial institutions, the influence that they have traditionally had over Treasury Department decisions, and the political vagaries of the electoral cycle, it appears extremely unlikely that the tough game-changing decisions needed to finally address "too big to fail" will be made from this perch. There certainly has been no compelling action from Treasury since DFA's passage that would suggest otherwise.

Indeed, there appears to be little appetite in Washington for using political capital to address the "too big to fail" problem. Instead, the political focus is understandably on the current fiscal crisis and the need for deficit reduction. The "too big to fail" problem and fiscal reform efforts, however, are very much linked, and failure to address the former may render the reform efforts meaningless. The recent financial crisis is largely responsible for the recent escalation of our national debt, as the government dramatically increased spending on stimulus- and bailout-related programs. Moreover, Standard & Poor's, in its recent warning on the government's credit rating, estimated that the up-front fiscal costs associated with bailing out financial institutions in the next financial crisis could total up to one-third of the nation's GDP -- $5 trillion. An amount even remotely close to this estimate would eclipse the total dollar figures at issue in the proposed fiscal reforms that are the subject of such intense debate today. It is therefore imperative, given DFA's reliance on political decision-making, that eliminating the "too big to fail" institutions' government safety net be included among the political priorities and shared sacrifices necessary for the United States to regain its fiscal footing. Otherwise, even if the two political parties somehow build a bridge to span their differences and reach a fiscal compromise, that bridge could be washed away by the flash flood of red ink required to bail out the banks yet again.

Adapted from the upcoming eBook, Dodd-Frank: One Year On.

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