Five years on, is Dodd-Franks too big to succeed?

On the fifth anniversary of the Dodd-Frank Act, the New York Federal Reserve has published a paper looking at whether the controversial legislation ended the spectre of "too-big-to-fail" financial institutions, for the US at least - particularly from the viewpoint of ratings agencies and bond markets.

The paper notes that the belief that very large banks may be too big to be allowed to fail appears to date back to the demise of Continental Illinois Bank in 1984, when regulators took "the unprecedented step" of protecting even uninsured investors, including large depositors, bond holders, and the shareholders of Continental's holding company.

Once again, from late 2007, the US government provided liquidity and capital support to some of the largest US financial institutions out of concern that a potential failure would threaten the entire financial system.

"A problem with such support is that it engenders expectations of future support that could motivate further increases in size to preserve or gain too-big-to-fail status.

"Moreover, when market participants expect institutions to receive support, they underprice their risk which invites excessive risk-taking (moral hazard) and pressures competing firms to do likewise," the Fed's paper notes.

To address this, the Dodd-Frank Act requires the Federal Reserve to impose increased prudential standards for the largest bank holding companies, and introduces new resolution mechanisms to deal with large financial institutions in distress. For instance, large, systemically important financial institutions must now submit resolution plans (also called "living wills") to the Fed and the Federal Deposit Insurance Corporation detailing their plan for rapid and orderly resolution under the US Bankruptcy Code in the event of failure.

In addition, the Dodd-Frank Act authorises the FDIC to wind down financial companies whose resolution under ordinary bankruptcy law might destabilise the financial system.

Rating agencies have different ways of indicating the level of government support an institution is likely to receive.

On the question of whether the Dodd-Frank Act has solved too-big-to-fail in the United States, the answer seems to be 'yes', according to Fitch, 'maybe' according to Moody's, and 'not yet' according to S&P. And while Fitch has removed its expectation of government support to US commercial banks and bank holding companies, Moody's still expects support for commercial banks, and S&P for commercial banks and bank holding companies.

However, S&P has indicated that it expects to revise its ratings of four US G-SIBS this year to reflect the reduced likelihood of government support for these institutions. Of course, this analysis only reflects the rating agencies' views.

"Since the Dodd-Frank Act makes it easier to intervene at the holding company level, we predict that, relative to the pre-Dodd-Frank era, investors' perceptions of the risk of holding bonds of a parent company would have increased relative to the risk of holding bonds of its subsidiary bank," the researchers wrote.

"To test this hypothesis, we compared how bond spreads evolved for a matched pair of bonds one issued by the parent company and one by its subsidiary bank.

"This approach led us isolate any differential effect of the new resolution procedure on the parent company relative to its subsidiary. A downside, though, is that there are only a few cases where both the parent and the subsidiary have the same bonds traded in financial markets.

"The evidence suggests that rating agencies and market participants may have some doubts about the ability, so far, of the Dodd-Frank Act to deal with 'too big to fail'."

However, another group of commentators have argued that once all provisions of the Dodd-Frank Act are implemented, any remaining expectations of government support will disappear.