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“Too big to fail” refers to the idea that the government would come to the rescue of a financial company that is so large or interconnected with other financial institutions that its demise would endanger the viability of the entire financial system.
 
The assumption of government support until now has caused credit rating agencies to assign higher debt ratings to large financial firms than these firms otherwise might have received, enabling them to issue debt at lower costs than many smaller financial companies, in effect giving them a competitive advantage. The assumption may also have caused stockholders and depositors to believe their investments in or funds held by large financial entities were relatively safe.

The concept, frequently in the news these days, isn’t new. Notably, in 1984, Continental Illinois National Bank and Trust’s excessive exposure to risky energy-sector loans, among other factors, eventually resulted in its seizure by the Federal Deposit Insurance Corporation. The FDIC pumped money into Continental and later sold it to BankAmerica, now Bank of America (BAC - Free Bank of America Stock Report). The government feared that the troubles at Continental, then the seventh-largest bank in the nation, could spread to the rest of the financial sector and hurt the economy. In Congressional proceedings later, Continental was referred to as too big to be allowed to fail.  Most depositors and many bondholders were bailed out, but shareholders took losses.
 
Fast forward to the financial crisis that began in 2007; the subsequent collapse of large financial companies, like Bear Stearns and Washington Mutual; and the $700 billion taxpayer-funded Troubled Assets Relief Program launched in late 2008 to bolster banks’ equity capital cushions and encourage them to lend. Much of the $700 billion went to the largest financial companies, again those viewed as too big to fail. Three institutions, insurer American International Group (AIG), and megabanks Bank of America and Citigroup (C), together accounted for $130 billion, or nearly a fifth, of the infusion.

In the aftermath of the latest crisis, Congress took action to avert the possibility that taxpayers would ever again be called upon to rescue big banks and other financial institutions. It passed The Dodd-Frank Act, a comprehensive overhaul of financial regulation in the U.S. , on July 21, 2010.  Among the law’s provisions are stricter standards regarding financial companies’ capital levels, liquidity, leverage, and risk management practices, and procedures for liquidating large failing institutions in an orderly fashion, including requiring banks to periodically submit  plans as to how they might be shut down should they fail (living wills). The provisions of Dodd-Frank will first be applied to banks, but are expected to be also extended to many nonbank financial firms.
 
All of the details have not yet been worked out as to how Dodd-Frank will be implemented (by January 21, 2012). But the law will have its greatest effect on institutions considered Systemically Important Financial Institutions (SIFIs), those with more than $50 billion of assets.
 
Public perception plays a big role here. Quite a few banks that fit into the large- but-not-largest banks category, like Huntington Bancshares (HBAN)  (just over the $50 billion threshold), have been lumped in with the likes of financial giants like JPMorgan Chase & Co. (JPM - Free JPMorgan Chase & Co. Stock Report), with over $2 trillion of assets. It’s probably safe to say that almost no one, including bank regulators, believes that Huntington is as systemically important as JPMorgan Chase.
 
But unless distinctions are made in ironing out how the new regulations will take effect, all of the $50 billion-plus institutions will have to play by the same rules, including submitting to more frequent stress tests and submitting capital plans to regulators before raising dividends. Implementing the stricter regulations will be costly, and the near-$50 billion banks will have a much harder time than the largest banks in bearing those expenses. The megabanks tend to have more diversified sources of revenues (including from their extensive investment banking activities) than mid-sized and small banks.

Some in the financial sector believe that setting the bar at $50 billion is meant to include a broad swath of financial institutions, with the aim of deliberately creating uncertainty as to which institutions might get too-big-to-fail support, and which investors, bond holders, and large depositors (those not covered by deposit insurance) might be protected in the event of a failure.

Others question whether any bank is really too big to fail. They argue that Dodd-Frank is meant to strengthen the financial sector and avoid the need for the government to bail out troubled institutions. Credit rating agency Moody’s (MCO) recently questioned whether the government would come to the rescue of any financial institution after the provisions of Dodd-Frank are carried out. But while not rescuing any troubled bank or financial company, large or small, might be more equitable than the current situation, it’s hard to believe that the government would ever not come to the aid of any of the largest financial institutions. Our sense is that it’s going to be hard to kill “too big to fail” in practice, as well as in the minds of investors.

To be sure, financial overhaul may permit the government to break up large institutions into smaller, less risky companies. But the law could have the opposite effect. Small and mid-sized banks that are having trouble bearing the costs of implementing the law may decide to merge, forming larger institutions, resulting in greater, not less, concentration of risk.

For now, with the details of the financial overhaul law still to be worked out and the survival of the too-big-to-fail concept in question, uncertainty reigns in the financial sector, making it hard for banks and other financial related concerns to plan for the future, and for investors to make informed decisions.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.