Too Big To Fail or Much Ado About Nothing? What Dodd-Frank Means to Small Businesses

15 january 2013

“Dodd- Frank…designates a number of banks as too big to fail, and they’re effectively guaranteed by the federal government. This is the biggest kiss that’s been given to — to New York banks I’ve ever seen.”

– Mitt Romney, First Presidential Debate, October 3, 2012

“Dodd-Frank provided a platform to make sure that we end some of the most egregious practices and prevent another taxpayer-funded bailout. We’ve significantly increased capital requirements and essentially created a wind-down mechanism for institutions that make bad bets, so the whole system isn’t held hostage to them going under.”
                – President Barack Obama, Interview with Rolling Stone, published October 25, 2012

I generally hate walking into political firestorms on the scale of the Dodd-Frank Act, but in light of all the discussion (and misinformation) about the law and its consequences, I wanted to dissect what exactly Dodd-Frank’s most controversial tenant—declaring certain institutions as “systemically important financial institutions”—actually means and what its effect is on small businesses.

First, let’s address the question on whether or not Dodd-Frank ends or codifies “too big to fail”. While Governor Romney is correct that Dodd-Frank does indeed designate eight U.S. banks as “systemically important financial institutions” (SIFIs), the rationale behind this labeling is to require these SIFIs to undergo annual stress tests, adhere to leverage limits and have increased risk-based capital requirements. Most importantly though, SIFIs whose failure could pose dangers to the U.S. financial system are required to be dissolved through an Orderly Liquidation Fund, which would be funded by other large financial institutions. Dodd-Frank states:

“…financial companies put into receivership under [the Orderly Liquidation Authority] shall be liquidated, [and n]o taxpayer funds shall be used to prevent the liquidation of any financial company under this title.”

Thus, if the Orderly Liquidation Authority is functioning properly, President Obama is correct that Dodd-Frank prevents the taxpayer bailouts that are synonymous with too big to fail. However, the operative word in the previous sentence is if because to date, the FDIC has not developed the operational capabilities to carry out orderly liquidation. While I will spare you all the gory details, the “orderly” liquidation of a SIFI poses a host of extremely difficult issues for the FDIC to craft rules around, the most problematic of which may be the international dimension of large financial institutions. Let’s say, for example, that JP Morgan (JPM) needs to liquidate. JP Morgan has assets in many countries around the world. Dodd-Frank is law in the U.S. So if the United Kingdom learns that JP Morgan is about to be liquidated by the U.S. government, it seems likely the UK will put a ring around JPM’s UK assets, preventing them from leaving the country in order to protect UK investors. Thus, while the Dodd-Frank Act and Orderly Liquidation Authority prevent taxpayer bailouts of SIFI institutions, unfortunately, until we see a SIFI fail according to “plan” taxpayers will be wondering whether Treasury will end up in front of Congress asking for bailout funds.

So what does designating some institutions as SIFIs mean for small businesses? While we don’t know the whole story yet, the answer, to date, appears to be very little. Critics have claimed that Dodd-Frank puts the community banks, which represent just 10% of banking assets but provide 40% of banking industry loans to small businesses, at a disadvantage by implicitly backstopping the SIFIs. However, credit default swaps, which provide insurance against banks defaulting on their debt, show that the large banks are viewed as less safe than they were pre-crisis, and some of the five biggest banks are viewed by investors are more likely to fail than others. This seems to discredit the notion that designating firms as SIFIs implicitly means they are too big to fail. Further, while loan growth for the U.S.’s four biggest banks has outpaced their smaller counterparts since Dodd-Frank (4% growth vs. 1%), growth in both groups has been anemic. While community banks’ return on equity remains well below pre-crisis levels, ROE has rebounded from -2.8% in 2009 to 8.4% by year-end 2011, and as Gary Corner of the St. Louis Fed notes, community banks’ ROE has been in a decade-long decline. Thus, while some estimate Dodd-Frank gives big banks up to 50 basis points funding advantage, the overall effect of the SIFI designation on small businesses and the community banks that fund them appears limited. There is another discussion about whether the Consumer Financial Protection Bureau mandated by Dodd-Frank will impose extra funding costs on community banks and thus small businesses, but that is for another post.

Republicans and Democrats have worked together this year on some initiatives that help small business financing, namely the JOBS Act (which benefits crowdfunding portals like mine, CircleUp). Those initiatives should be celebrated for the impact they will have job creation and small business growth.  Dodd-Frank’s impact on small businesses, however, remains unclear at best.