September 2008 was an extraordinary month, even by the standards of an extraordinary crisis. We witnessed the failure of Lehman Brothers, the rescues of AIG (NYSE:AIG), Fannie Mae (NYSE:FNM), and Freddie Mac, and the conversion of the remaining bulge bracket investment banks into bank holding companies. As we mark the one-year anniversary of one of the most tumultuous months in the history of modern finance, it's worth pausing to ask: One year on, what has changed, and what hasn't?

Banks are better capitalized
As the following table shows, the largest banks have significantly improved their capital ratios (or reduced their leverage, if you prefer). Those firms that were thought to be at greatest risk, including Citigroup (NYSE:C) and Bank of America (NYSE:BAC), have appropriately made the greatest strides:


Tier 1 Capital Ratio (End of Q2 2009)

Tier 1 Capital Ratio (End of Q2 2008)

Goldman Sachs (NYSE:GS)






Bank of America



Wells Fargo (NYSE:WFC)



JPMorgan Chase (NYSE:JPM)



Source: Capital IQ, a division of Standard & Poor's.

... But they remain "too big to fail"
Witnessing the financial and economic repercussions of the failure of Lehman Brothers last September has only reinforced the notion that the largest, most interconnected institutions are "too big to fail" -- it's unlikely the government would allow the system to endure that sort of stress again.

Furthermore, with the disappearance of Lehman, Bear Stearns, Washington Mutual, and Wachovia, the banking and securities industries have become more concentrated at the top than they were prior to the crisis. In that respect, the risks associated with a major bank failure have actually increased.

Banks that are "too big to fail" benefit from an implicit taxpayer subsidy since their funding costs do not adequately reflect the risk of failure. That subsidy, in turn, creates an economic incentive for banks to grow large enough to achieve "too big to fail" status. We urgently need to abrogate that subsidy and put an end to that vicious cycle.

Preparing for death
As such, the creation of so-called "living wills" for these organizations is one of the most pressing items of reform for the financial sector. A living will would spell out a systematic regime under which a failing institution could be wound down; the existence and application of such contingency procedures would avoid creating a shockwave that would reverberate throughout the rest of the financial system.

Shareholders can also play a positive role: It wouldn't be absurd for the owners of some of these banks to ask management whether these institutions have simply become too big to manage on a day-to-day basis, let alone too big to fail. In some cases, a breakup or, at the very least, a tight rationalization of activities may be just what the activist investor ordered.

Fannie Mae, Freddie Mac stabilized ... for now
Speaking of "too-big-to-fail," the real poster children for that problem are mortgage giants Fannie Mae (NYSE:FNM) and Freddie Mac. Formally known as "government-sponsored entities" (GSEs), these miscreants proved that sponsorship doesn't come cheap in a crisis -- to the tune of up to $400 billion in direct aid pledged by the government (without even mentioning the $5.2 trillion in mortgage securities the two GSEs own or guarantee).

Fannie and Freddie were and continue to be two hybrid monstrosities with private shareholders and a political mandate ("Increase home ownership whatever the cost, and keep the political contributions coming!"). At least now, the companies openly state that they are not being run with the goal of maximizing shareholder returns.

Despite the government's intervention, Fannie and Freddie's ultimate fates remain unknown. While the Obama administration has mentioned several different options, it doesn't expect to disclose its plans until the beginning of next year. I fear the worst: Given the special interests involved and the complexity of the project, a "muddle through after fixing it with Scotch tape and rubber bands" solution looks a lot more likely than the bold solution that is required.

Firefighting vs. fire prevention
The government took some necessary steps to stabilize the financial system last September. However, that was firefighting, not fire prevention. Much remains to be done if we are to reduce the risk and severity of future crises (I'm not naive enough to believe that we can actually prevent crises altogether, since they are consonant with human nature). Ensuring that no institution is too big to fail should be one of our first priorities.

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Alex Dumortier, CFA, has a beneficial interest in Wells Fargo, but not in any of the other companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.