Dodd-Frank's Too-Big-to-Fail Dystopia The government expands crony capitalism to insurers, securities firms and other non-banks.

Dodd-Frank's Too-Big-to-Fail Dystopia

The government expands crony capitalism to insurers, securities firms and other non-banks.

With the recent publication of its final rule, the federal government's Financial Stability Oversight Council is now in position to designate certain nonbank firms as "systemically important financial institutions" (SIFIs). Under the Dodd-Frank Act, that label can be attached to nonbank financial institutions—insurers, financial holding companies, hedge funds, finance companies, securities firms, perhaps even money-market mutual funds and private-equity firms—that will "pose a threat to the financial stability of the United States" if they fail.

This process has received relatively little attention in the media, but there is probably no aspect of the Dodd-Frank Act that will have more damaging effects on competition in the U.S. financial system.

Almost daily, we hear politicians and commentators complaining that large banks like J.P. Morgan Chase are too big to fail and put the taxpayers at risk. But few seem to recognize that the Oversight Council's designations will spread the too-big-to fail problem beyond banking to every other financial industry.

The capital markets are not populated by fools. When the council has declared that a firm is "systemically important"—that its failure poses a threat to U.S. financial stability—the U.S. government is effectively saying that it will do whatever it takes to prevent the firm from failing. This means that a loan to a "systemically important" institution is going to be safer than a loan to a smaller competitor without that designation.

This is not speculation. The banking industry is already made up of a host of smaller banks and a few huge banks that are widely considered too big to fail—and the biggest banks have a lower cost of funds than their small competitors, as Thomas Hoenig (then of the Kansas City Federal Reserve Bank, now of the Federal Deposit Insurance Corporation) and others have shown. Fannie Mae and Freddie Mac, thanks to their government backing, also had advantageous funding, so much so that they drove even the biggest banks from much of mortgage market.

In testimony last week to a House subcommittee, MetLife executive William Wheeler put it clearly: "A SIFI designation would be the federal government's signal that we are indeed 'too big to fail,' and that if we got into financial trouble, federal funds would be used to rescue the firm. The implicit backing of the federal government could strengthen perceptions of our creditworthiness and may give us a significantly cheaper cost of funds than our peers."

It's not difficult to imagine what would happen to competition in the U.S. after SIFIs are designated in nonbank financial industries. These industries would consolidate, with larger companies using their funding advantage to absorb the smaller.

Defenders of the SIFI designation say it will do no harm. All such institutions will be turned over to the Federal Reserve for "stringent" regulation, they argue, and this will be so costly that any funding advantage will be overcome. That certainly hasn't happened in the Fed's regulation of the biggest banks, but even if it does happen in the case of SIFIs it wouldn't be much consolation.

Logic says that one of two things is likely to be true: Either the funding benefits realized by SIFIs will be larger than the regulatory costs, or the regulatory costs will overwhelm the funding advantages. The chance that they will balance out is negligible.

Either we will have large, successful, government-backed firms that swallow up smaller competitors, or we will have large, unprofitable, heavily regulated giants that are gradually driven to failure by their more nimble and less regulated competitors. In the former case, small firms are the victims. in the latter case, taxpayers will pay for the bailouts. Pick your dystopia.

One of the most surprising things about the SIFI designation process is how little attention it's received from smaller firms. They seem to think that this is a potential problem only for the firms that are in danger of being labeled systemically important. But both the big and the small could have a major stake in what the government's Oversight Council ultimately does, and their Washington representatives should be saying so to Congress.

Crony capitalists and their government mentors will be the biggest winners. Concentrated and heavily regulated markets are fine with supporters of the Dodd-Frank Act. They are comfortable with a financial industry made up of a few large firms responsive to government direction. If the government's SIFI designation is allowed to continue, that's precisely what we'll get.

Full article can be seen here:  http://online.wsj.com/article/SB10001424052702303610504577420234053483326.html