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posted on 12 November 2016

Did Dodd-Frank End 'Too Big To Fail'?

from the Philadelphia Fed

-- this post authored by Ryan Johnston

Despite reforms, do big banks still benefit from market perceptions that the government will bail them out if they falter?

During the financial crisis in 2008, the U.S. government bailed out some very large banks for fear the collapse of any bank that large would profoundly harm the U.S. economy and destabilize the global financial system. That is, they were too big to be allowed to fail. Passage of the Dodd - Frank Act two years later was intended to rule out future bailouts through tighter safety-and-soundness requirements, among other measures. Yet, some worry that investors may still view certain banks as “too big to fail," a perception that would confer an arguably unfair and potentially risky funding advantage over smaller banks. If a bank’s uninsured depositors or bondholders expect to be protected against losses, they will accept lower interest rates. So, in principle, we should be able to compare the rates paid by the largest banks with those paid by smaller banks for evidence of whether Dodd - Frank was successful in eliminating markets’ bailout expectations. But as this review will explain, the many differences between large and small banks make it hard to know whether we are comparing apples with apples. We review studies that address this apples-to-apples problem and help determine whether large banks still receive what is, in effect, a government subsidy.

A primary stated goal of Dodd - Frank is to get rid of the perception that the largest banks are too big to fail (TBTF). It aims to do so through a number of mechanisms. An annual stress test is required for banks with assets greater than $50 billion. The test uses hypothetical economic and financial market scenarios of varying severity to measure the impact on the value of banks’ capital. If the test indicates that a bank’s capital levels would fall below regulatory requirements under the severe stress scenario, the bank might be prohibited from making any dividend payments or other capital distributions. The results of banks’ stress tests are posted on the Federal Reserve Board of Governors website and widely reported. Maintaining capital levels that internally absorb economic shocks strengthens public confidence that big banks will not need to be bailed out during an economic or financial downturn.

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Source: https://t.e2ma.net/click/871un/gugril/ogjitd

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