Does Dodd-Frank Legislation End Too Big to Fail?

June 23, 2012

By: Steve Liesman, CNBC

The long-awaited downgrade of big banks by Moody’s highlights a raging debate among investors, regulators and politicians: Does the Dodd-Frank legislation end “too big to fail” or bake it into law?

The answer found in the Moody’s report is, unfortunately, both.

In downgrading some of the biggest U.S. banks — Bank of America [BAC  7.94    0.12  (+1.53%)  ], Citigroup [C  27.99    0.16  (+0.57%)   ],Morgan Stanley [MS  14.14    0.18  (+1.29%)   ]and Goldman Sachs [GS  93.63    -0.27  (-0.29%)  ] — Moody’s specifically cited the changed outlook for a government support bailout in the event of a large bank failure. It specifically cited what it sees as the commitment of Federal Deposit Insurance to follow Dodd-Frank rules and end “bailouts of ‘too big to fail’ institutions.”

Score one for Dodd-Frank  , right? Not so fast.

What Moody’s actually said in its report is: “Put simply, we believe government support for creditors of bank holding companies is becoming less certain and predictable.”

However, the ratings agency made a significant distinction between creditors to the holding companies and the operating companies, which is the actual bank that holds the deposits.

In the actual banks, Moody’s said: “Support for creditors of operating entities remains sufficiently likely and predictable to warrant stable outlooks.” That is, Moody’s thinks the government will still bail out those creditors.

So there’s the rub: On the one hand, Moody’s sees the resolution plan in Dodd-Frank ending too big to fail by forcing creditors at the bank holding companies to take losses. On the other hand, it sees the regulators practically enshrining it in law by offering support to the operating company creditors.

“We’re still not sure if the resolution plan is workable, and there are competing priorities, which are at times irreconcilable,’’ Bob Young, Moody’s managing director of North America banking, said in an interview.

Regulators are trying to balance two competing interests. First, they want to avoid systemic risk and contagion while at the same time making creditors pay for a bank’s losses so taxpayers are not on the hook.

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