Have Regulators Solved the Too Big to Fail Problem?

One of the purposes of the Dodd-Frank Act of 2010 was to address the problem of too-big-to-fail banks. Was it successful at doing so? Is it even in the interest of ordinary Americans to do so?

In this week's episode of Industry Focus: Financials, The Motley Fool's Gaby Lapera and John Maxfield dig into the too-big-to-fail issue and come to some uncomfortable conclusions.

A full transcript follows the video.

This podcast was recorded on Feb. 13, 2017.

Gaby Lapera: One of the charges that has been laid against Dodd-Frank's feet is that the federal government now has an inability to intervene, should there be another financial crisis. 

John Maxfield: This goes back to the whole point of Dodd-Frank. It's not so much that they have the inability to intervene, but it narrows their options and their powers in the event that they do have to intervene. Again, this all goes back to the original purpose of Dodd-Frank, which was not only to prevent another financial crisis like the one in 2008, but to solve the "too big to fail bank" problem. The thought process was, if you tell the regulators that they can't rescue too big to fail banks, then the banks will do everything in their power to make sure that they don't fail. It's attacking the moral hazard problem, and it makes sense in theory, but like anything, the devil is in the details.

Lapera: Absolutely. The other thing that you mentioned, that I have heard multiple times, is that if the banks are too big to fail, that doesn't even make sense, if banks are not doing the right thing, we should just let capitalism do what capitalism does, and we should just let the banks fail, and we'll see what happens when the dust settles. It's not a great idea, in general. I know that there are some people here who really hate central banking who listen to this show. I've had emails from them. But, in general, not a really great idea to let your entire economic system collapse. The problem with when these too big to fail banks collapse is in the name -- they're too big to fail because, when people make a run on them, when they collapse, there's no banking infrastructure left.

Maxfield: Here's what I would recommend to any listener who's thinking about this and who is opposed to this idea of bailing out big banks -- I agree, Gaby agrees, everybody agrees that bailing out these bankers when they get into trouble is a very unpalatable course of action today. These guys make a ton of money.

Lapera: It's not ideal, no. [laughs] But the other option...

Maxfield: Right. If you look back in history, the thing that we know, and this is what Milton Friedman became famous for, was that when there is a contraction in the money supply, that is the thing that kicks you into a recession. And if there is a big contraction in the money supply, that is what kicks you into a depression. Banks are not ordinary companies. This is not like Best Buy or Wal-Mart. Banks play a critical role in the money supply, because they both hold deposits and make loans, which creates money. So, if you allow one of these really big banks to fail -- and the four big banks have an enormous amount of market share in the banking and deposit industry in the United States -- if you allow one of them to fail, the contraction in the money supply would be so steep that it would almost certainly -- and I am choosing that adjective purposely -- it would almost certainly cause a depression. Not a recession, but a depression. So you have to ask yourself, do you swallow the unpalatable option of bailing out these dozens of bankers when they make these mistakes in order to prevent a Great Depression? Or, do you punish those dozens of bankers and then punish the rest of the entire country, and -- because of the way the global economy is connected, the rest of the entire world -- because of the mistakes that these guys have made? I personally don't think that you should do the latter. I think, you should punish those bankers to the extent that you can, swallow that unpalatable option, but save the economy from falling into a depression.

Lapera: Yeah. Exactly what you said. And it's hard, because it's not what you want. You want there to be a consequence for bad actions. But the problem is, like you said earlier, if a Wal-Mart fails, it's just Wal-Mart. If Wal-Mart fails, the market corrects. When banks fail, the market doesn't correct fast enough. There's no correction if the market is gone, which is, I think, something that people miss when they're like, "Ah, just let them fail." I mean, we do have those resolution plans, but that's if there's enough law and order to make sure that the banks get broken up properly. This is a whole 'nother topic of conversation.