Does Dodd-Frank Legislation End Too Big to Fail?

The long-awaited downgrade of big banks by Moody’s highlights a raging debate among investors, regulators and politicians: Does the Dodd-Frank legislation end "too big to fail" or bake it into law?

The answer found in the Moody’s report is, unfortunately, both.

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In downgrading some of the biggest U.S. banks — Bank of America , Citigroup , Morgan Stanley and Goldman Sachs — Moody’s specifically cited the changed outlook for a government support bailout in the event of a large bank failure. It specifically cited what it sees as the commitment of Federal Deposit Insurance to follow Dodd-Frank rules and end “bailouts of ‘too big to fail’ institutions.”

Score one for Dodd-Frank , right? Not so fast.

What Moody’s actually said in its report is: “Put simply, we believe government support for creditors of bank holding companies is becoming less certain and predictable.”

However, the ratings agency made a significant distinction between creditors to the holding companies and the operating companies, which is the actual bank that holds the deposits.

In the actual banks, Moody’s said: “Support for creditors of operating entities remains sufficiently likely and predictable to warrant stable outlooks.” That is, Moody’s thinks the government will still bail out those creditors.

So there’s the rub: On the one hand, Moody’s sees the resolution plan in Dodd-Frank ending too big to fail by forcing creditors at the bank holding companies to take losses. On the other hand, it sees the regulators practically enshrining it in law by offering support to the operating company creditors.

“We’re still not sure if the resolution plan is workable, and there are competing priorities, which are at times irreconcilable,’’ Bob Young, Moody's managing director of North America banking, said in an interview.

Regulators are trying to balance two competing interests. First, they want to avoid systemic risk and contagion while at the same time making creditors pay for a bank’s losses so taxpayers are not on the hook.

The balance under discussion right now would try and keep the unsecured creditors from fleeing a sinking ship. This means providing support for unsecured creditors who have deposits above the deposit guarantee level, for hedge funds and their free balances in prime brokerage accounts and for overnight lenders in the repo market. Anything less could exacerbate the bank’s failure and, hence, possible losses to the deposit insurance fund. Indeed, it was the departure of these creditors when there was the first whiff of trouble at Lehman andBear Stearns that led to their accelerated demise.

The current thinking at the FDIC is to put the holding company into receivership and use those assets to fund the operating company. As a result, “the equity solvent subsidiaries would remain open and continue to operate.”

All of this stems from a controversial section of Dodd-Frank givers regulators “resolution authority,” or the ability to wind down big bank failures in a process that is similar to, but not quite, a bankruptcy procedure. Republicans are trying to overturn this portion of the bill, arguing that it only enshrines too big to fail.

Moody’s report shows that markets find this to be true and not true. Downgrading the outlook for the holding company creditors suggests Dodd-Frank is successful at making investors believe there has been progress in ending too big to fail. But leaving stable the outlook for the operating company shows big bank creditors could still get a free-ride.

Regulators and those who support the new financial rules could see the Moody’s report as a limited victory. A central thrust of the new policies has been to make it more expensive for banks to be big and pay for the systemic risk their failure could create. New capital requirements agreed to under Basel III, in fact, require big banks to have higher capital requirements just to pay for being big.

The Moody’s downgrade itself, citing changing government regulations, raises the cost of capital for big banks, making it more expensive for them to be large and, in essence, complementing the thrust of policy.

But it also shows that really ending too big to fail and at the same time avoiding systemic financial risk is tricky and it may never be possible to do both completely.