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Too big to fail is going out of style, says new GAO report

Spencer Platt

A new report released Thursday by the Government Accountability Office confirms that America's most underrated law, the Dodd-Frank Wall Street Reform and Consumer Protection Act, is working and making a real difference. In this case, "working" means reducing market perceptions that the largest banks will receive special subsidies from the government in the event of trouble, and therefore reducing the advantages those banks enjoy during normal times.

What did they study?

Sherrod Brown, a Democratic Senator from Ohio who's one of Congress' toughest critics of the banking industry, asked the GAO to look at a particular advantage megabanks have long been suspected of receiving. If certain institutions are perceived as "too big to fail" and likely to receive a bailout in a time of crisis, then there is little risk in lending to them during good times. That should give the biggest banks access to discount loans compared to what smaller banks receive.

At Brown's behest, the GAO examined this issue both before and after the Great Crash of 2008.

What did they find?

GAO had two major findings. One is that before the crisis, financial markets acted as if they assumed bailouts would be forthcoming. Consequently "the largest financial institutions had lower funding costs during the 2007-2009 financial crisis."

But more recently, things look different and "the difference between the funding costs of the largest and smaller institutions has since declined." They also did some statistical modeling which, likely, showed that "large bank holding companies had lower funding costs than smaller ones during the financial crisis" but since that time "such advantages may have declined or reversed."

Why does this matter?

Both left-wing and right-wing critics of the Obama administration's financial regulation initiatives have levied the charge that Dodd-Frank did not end "too big to fail" or reduce the future need for bailouts. These phrases are open to a variety of interpretations, but the GAO study shows that large banks really are subject to increased market discipline these days.

It is certainly possible that the biggest banks retain some residual advantage and that additional regulatory measures against them are warranted. But Dodd-Frank has clearly made some meaningful strides in this direction, among others.

What are the limits of this study?

The GAO was asked to examine a politically potent but rather narrow question of whether large banks receive an implicit bailout subsidy relative to smaller banks. It is entirely possible that banks of all size are allowed by regulators to carry too much debt, and that markets let them get away with it because of bailouts and moral hazard. The GAO is saying that the gap between the bailout subsidies received by large and small banks has shrunk considerably, not that the banking sector as a whole is receiving no bailout subsidies.

Another important point, made by Mike Konczal, is that the GAO can't really distinguish between disastrous and non-disastrous liquidations of a large bank holding company. They are telling us that creditors will bear losses which, again, is important for the fairness question. But it's hardly the only interesting question one might ask about the process.