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A top ratings agency thinks big banks may not get bailouts next time around

Jamie Dimon speaks during the Fortune Global Forum.
Jamie Dimon speaks during the Fortune Global Forum.
Kimberly White/Getty Images

The bond rating giant Standard & Poor's delivered a dose of bad news for America's largest banks and good news for the Obama administration's Wall Street reforms on Thursday morning, slightly downgrading its rating of eight major banks because they think they are less likely to get a government bailout if they run into trouble. Importantly, S&P isn't saying the banks won't get a bailout because it thinks political paralysis will lead Washington to allow a chaotic collapse of the global financial system. Instead, they are saying that in light of "progress made toward putting in place a viable US resolution plan," it is becoming less likely that bailouts will actually be needed.

This is in line with conclusions reached by experts like the Roosevelt Institute's Mike Konczal, who's previously written for Vox about both the substantial progress that has been made toward this goal and the existence of some ongoing need for improvement.

Dodd-Frank is making a difference

Driving S&P's conclusion is the financial reform legislation co-authored by former Sen. Chris Dodd and former Rep. Barney Frank that President Obama signed in 2010 and that is in many ways his most underrated piece of legislation.

The law has many moving pieces, but the two most important ones from the perspective of preventing bank bailouts are called single point of entry and living wills.

Single point of entry is a concept developed by the FDIC that should help it manage the failure of a large, complicated bank without destroying the rest of the financial system. A temporary company would come in and manage critical operating subsidiaries while the firm is being liquidated. This would result in the same losses necessary for fairness and justice, without the risks to the broader economy. FDIC-managed liquidation is basically what happens when small banks fail, but pre-Dodd-Frank regulators felt the tools simply weren't in place for the FDIC to manage a diversified financial institution.

Living wills are a new kind of document required by the law, in which large diversified financial institutions are supposed to write down plans that bankruptcy courts could follow in order to manage failure in a quick and orderly manner. Living wills, if they worked, would completely eliminate the need for bailouts, but so far banks haven't actually produced them in a satisfactory manner. According to the FDIC, the first drafts of these "are not credible and do not facilitate an orderly resolution under the US Bankruptcy Code."

A key question for Clinton is how she will manage enforcement of the living will issue. So far, banks have not managed to gain approval for their living wills but also have not faced penalties for having done so.

Republicans want to undo all of this

The term "bailout" is inherently somewhat fuzzy, and Republican critics have decided that any form of orderly liquidation constitutes a "permanent bailout"; removing OLA authority is a major plank of Paul Ryan's budget.

This raises the question of what, in practice, Republicans think should happen if a major bank fails. On the surface, if we remove OLA and repeal Dodd-Frank we go back to the legal situation that prevailed in 2008, where, in theory, bankruptcy courts are supposed to handle failure. This is exactly what was done with Lehman Brothers, sparking financial panic, and then fear of future panics led to the Bush administration embracing massive ad hoc bailouts.