The end of Too Big to Fail?

| March 2, 2012 | 0 Comments

Bankers are shocked at a recent turn of events: the Federal Reserve may actually prevent them from getting their way.

Dodd-Frank, the new financial law approved after the crisis, forces regulators to look at more criteria before deciding whether to approve mergers. Regulators must now consider whether combining two institutions might threaten “financial stability” — not just of the new institution, itself, but also of the entire US financial system. (Why they haven’t they been doing this all along?)

Last year Capital One decided to buy ING Direct. It was only the second time that the Federal Reserve was asked to approve a merger under the new regime. Before saying yes, the Fed looked specifically at whether the merger might create a new institution so large or so complex that its failure might damage the broader economy. This seems basic, but as law firm Sullivan & Cromwell notes, the belief that larger institutions are inherently more risky is a new attitude from the Fed.

This is an unpleasant surprise for an industry that’s used to arguing that bigger is better. In other words, right now the Fed looks like it will not allow any more of the institutions it regulates to become Too Big to Fail. As Sullivan & Cromwell says:

The impact of this position on future merger and acquisition transactions by larger (and certain systemically significant) bank holding companies, or nonbank financial companies supervised by the FRB [Federal Reserve Board], could be serious.

We should hope so. In addition to size, the Fed is also looking at the level of “interconnectedness” the new firm would have with the broader financial system. For example, banks that are big in securitization will face more scrutiny.

One other interesting change in the Fed’s approach. Before giving it permission to acquire, the Fed will actually look at the company’s record of not breaking the law:

In addition, the Capital One Order reflects an unusually strong focus on consumer compliance matters. This indicates that all applicants to the FRB, regardless of size, should be prepared for significant scrutiny of their compliance records, particularly with respect to matters that have attracted public attention as a result of litigation or customer complaints.

All of this adds up to a new, more stringent approach. Contrast this with the approach taken for the 1998 merger that created the Too Biggest to Fail of them all, Citigroup. Here’s the former co-CEO of Citigroup, John Reed, talking to Bill Moyers earlier this year:

BILL MOYERS: Because if in that two-year period as I understand it, Glass-Steagall had not been changed, this merger — which had already taken place — would have been illegal.

JOHN REED: We would have to take it apart. And we took steps to make sure that was possible.

BILL MOYERS: But you got the blessing in this two-year period of President Clinton, of the Fed, of–

JOHN REED: We had that blessing prior to. In other words—

BILL MOYERS: What? They assured you that this—

JOHN REED: Yes.

BILL MOYERS: Glass-Steagall would be–

JOHN REED: Yes. In other words, I went with Sandy to call on Chairman Greenspan. We told him we were contemplating this merger. But that it would require that the Fed would be prepared to grant us permission. And we were assured that they would.

Bankers are upset — “I almost fell off my chair,” said one to the FT when asked about the Fed’s new attitude. But the rest of us should like what we see.

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Category: Banking