Are Some Companies Still Too Big to Fail?

“Too big to fail” banks were one of the defining economic problems of the late aughts and early 2010s. The 2008 financial crisis brought into painfully clear focus an issue that helped create the worst economic downturn since the Great Depression: Many of the biggest financial institutions in the U.S. could threaten to unravel the entire economy if allowed to fail, and many of them were in deep trouble.

The failure of investment bank Lehman Brothers in September 2008 set off a domino effect and a growing financial contagion that saw Congress step in with an urgent $700 billion bailout bill.

No one knows what would’ve happened if this unprecedented bailout never happened, but the possibility of economic chaos, which was already quite ugly, was seen as too great to risk. The bailout showed that the government did consider some banks simply too big to fail.

Moral Hazard and the State of Too Big to Fail Banks

At a time when so many Americans were losing their jobs, their homes and their retirement savings, public resentment of Wall Street grew. The fundamental issue was something called moral hazard: Bailed-out banks took huge risks with depositors’ money and then got a check from taxpayers when things went south.

This issue of moral hazard is at the center of why the concept of too big to fail institutions was lambasted on Capitol Hill and bitterly criticized on Main Street. It incentivizes destructive risk-taking and limits repercussions.

In 2020, with the economy threatened by a global pandemic and incredible uncertainty, it’s time for a checkup: Where is the U.S. now on the issue of too big to fail banks?

[Read: 3 Ways to Find an Undervalued Stock.]

Banks Are Bigger Despite More Regulation

One thing is undeniable: Big banks are bigger than ever in 2020. Between 2008 and 2011 or so, commercial banks held about $12 trillion in assets. Fast forward to 2020, and that number has soared to more than $20 trillion for the first time, according to data published by the Federal Reserve Bank of St. Louis.

Assets held by the largest 25 banks soared from $8.1 trillion at the end of 2009 to $13.3 trillion by March 31, the Federal Reserve’s data shows.

But size is just one factor. Dodd-Frank, a set of sweeping Wall Street reforms and regulations, enacted much stricter risk controls and oversight, including regular “stress tests” that gauge the ability of large financial institutions to handle nightmarish economic scenarios.

“It is not an apples-to-apples comparison to look at the size of the largest banks then versus now. More important, you must look at the risk profile of the banks and the rules implemented under Dodd-Frank,” says Eric M. Corrigan, senior managing director at Commerce Street Capital. “Demonstrably, the largest U.S. banks have much more capital, liquidity and risk management in place. They have largely de-risked their balance sheets and exited businesses that led to losses in the last crisis.”

David Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business, agrees: “Unlike 2007 to 2009, the largest banks are very well-capitalized and recently passed an annual stress test. The major bank regulators have not expressed any concerns” about too big to fail to be a major problem.

Even if the specter of too big to fail banks appears to be less concerning to experts and regulators in 2020 than it was a decade ago, the warning signs of excessive leverage and illiquidity that threw the global economy into recession in 2008 are being closely monitored.

Kass notes that the Federal Reserve has suspended stock buybacks at big banks in the third quarter to deal with the unknown potential fallout from the pandemic. The Fed also capped dividends at a certain percentage of income.

Still, some banks will always be more flimsily positioned than others, and some cracks have begun to emerge at major U.S. banks. “Wells Fargo did recently cut its cash dividend by 80% as a result of a quarterly loss resulting from adding to its reserves as it anticipates loan losses” from the pandemic, Kass says.

Wells Fargo (ticker: WFC) certainly isn’t the only bank setting aside major money for loans that may go sour. Along with JPMorgan Chase ( JPM) and Citigroup ( C), those three Wall Street titans set aside a combined $28 billion in reserves last quarter alone.

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Risks Remain Even With Improved Guardrails

The headline lesson for financial regulators — that too big to fail banks are ugly, undesirable cogs that can suddenly threaten to bring the whole economic machine crashing down — seems to be well understood and heavily guarded against.

Some more obscure points, like the interconnectedness of today’s global financial system, modeling assumptions that don’t take the worst crises into account, and the heavily conflicted, for-profit credit rating agency model, have arguably been overlooked.

One recent example of how flawed modeling can be is found in 2020’s Federal Reserve stress tests, which were created in February. In the “severely adverse” scenario, the Fed modeled what would happen if the unemployment rate hit 10% by the third quarter of 2021.

In reality, two months later, the U.S. unemployment rate was at 14.7%, nearly 50% higher than the central bank imagined it could possibly get over the span of 18 months.

Additional, more dire Fed simulations conducted in the wake of the pandemic showed about a quarter of the 33 big banks tested getting close to violating minimum capital reserve ratios, according to a report from S&P Global Market Intelligence.

While the financial machine is still imperfect, the Fed can at least be expected to keep a close eye on how big banks are capitalized in the current crisis.

[READ: How to Retire During a Pandemic.]

“The rules are working as intended, and we would not expect large-scale failures even if the current economic recession is prolonged,” Corrigan says. Corrigan is less worried about big banks and more concerned about another squeaky cog in the economic machine.

“More of the risk in our system is in nonbanks — unregulated entities,” Corrigan says, pointing out that some of the largest mortgage lenders and unsecured consumer debt lenders aren’t actually banks. Obscure derivatives like collateralized mortgage obligations and collateralized debt obligations are also largely owned by “funds, not banks,” Corrigan warns. “This is where we have and will see weakness in the system.”

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Are Some Companies Still Too Big to Fail? originally appeared on usnews.com

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