Is too big to fail back?  We’re not yet too old to party, so we were hoping not to have to think about this until next week, at the earliest.  But an article in the American Banker got us focused on it now because of all the statements in it that argue that, no matter what the FDIC does, too-big-to-fail financial companies are a fact of life.  This will fuel calls from the left and right to revisit Title II, the “orderly liquidation” provisions in Dodd-Frank, repealing them in favor of bloody-minded bankruptcy for all, including the biggest of the big.  If this movement gets going next year – and we fear it will – the U.S. could find its still-fragile financial system further destabilized without any meaningful dent in moral hazard.

Sen. Shelby has called Title II a “honey pot,” and House leaders like incoming FinServ Chairman Bachus haven’t been any more polite.  Title II is, though, a far cry from the Administration’s initial resolution proposal.  When it came out in March of 2009, we called it TARP on steroids because it would have allowed the regulators to rescue anyone anytime they felt the urge.  This proposal engendered considerable suspicion on the left and right – and some in the middle, for that matter – that the Administration was still loving moral hazard too much.  This deeply damaged Treasury’s credibility throughout the next year’s worth of Dodd-Frank negotiations.  However, Title II is a very strict law, creating a resolution regime that is bankruptcy in all but one respect: to prevent systemic chaos, the FDIC can establish a “bridge” institution to operate in lieu of the failing firm until danger is past.  Should any of this cost the government, then big firms – not taxpayers – will pick up the tab.

This tough-minded U.S. approach is dramatically different from those under consideration in the EU and other nations with global-sized banking organizations.  Instead of shutting down the biggest banks, these policy-makers want to establish procedures to ensure that investors are at risk (so-called “bail-in” debt) and that taxpayers are reimbursed in advance for any rescues through new taxes on the biggest banks.  Instead of ending TBTF, these policies memorialize it.

As a result, there’s already a wide divide between U.S. law in the wake of Dodd-Frank and TBTF in other major financial centers.  The only common thread is the U.S. bridge institution, which provides some comfort that, under stress, a major bank or financial market utility would not have its lights suddenly turned off.  All of the debate about systemic risk has focused on TBTF institutions because, of course, some of these brought global finance to the brink in this crisis.  But, we had another one – 9/11.  When the planes hit the towers, they knocked out a critical part of the payment infrastructure.  The FRB stepped in with billions as the banking system struggled to remain operational.  It turned out then that a bridge wasn’t necessary, but what about the next time?

Sometimes, systemic risk doesn’t come from the moral lapses that lead to moral hazard.  It can come from operational risk like that experience on September 11 or from contagion risk, when the good are threatened by the acts of the bad on whom they once depended for critical financing, services or other functions.  If a renewed bout of anti-TBTF fervor takes hold next year, then the cables suspending this bridge could well be cut.  If so, the U.S. won’t have any moral hazard, but we also might not have a resilient financial system able even under stress to offer the services on which global finance depends.

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