Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management.

John E. Parsons is a senior lecturer in the finance group at the Sloan School and co-author of the blog bettingthebusiness.com.

At this point, no one will stick up for too-big-to-fail financial institutions. Even Tim Pawlenty, the newly appointed head of the Financial Services Roundtable, a group that represents big banks, contends that we must end the phenomenon of too big to fail. No financial institution should be so big — or so systemically important for any reason — that its failure would jeopardize the macroeconomy.

Today's Economist Perspectives from expert contributors.

The question of the day has therefore become whether too big to fail is already dead and buried or whether, like some resilient and unsavory zombie, it still stalks within our financial system.

In a speech on April 18, Mary Miller, Treasury under secretary for domestic finance, made the case that the Dodd-Frank reform legislation has substantially ended the problem of too-big-to-fail financial institutions. This is a well-composed speech that everyone should read — and then compare with the broadly parallel messages coming from parts of the financial sector (e.g., see the presentation of the Clearing House, an association of banks).

The original written version of Ms. Miller’s speech did not contain footnotes or precise references to the sources on which she drew, but the Treasury Department was kind enough to share this information with us and has now posted a version of the speech with links to sources; this is also most helpful. As a result, we are able to evaluate Ms. Miller’s arguments in some detail.



Ms. Miller’s argument rests on eight main points. On each there is a serious problem with her logic or her reading of the data, or both. Taken together, we find her position to be completely unpersuasive. Unfortunately, the problem of too big to fail still lurks.

First, Ms. Miller makes a great deal (at the top of Page 2) out of legal changes under Dodd-Frank that make it harder to bail out financial institutions. She is right on the formal changes but misses the essence of the issue. The question is not whether the government can swear up and down not to provide bailouts or some other form of support, but rather whether such commitments are credible. If banks are so big or so linked to the rest of the economy that their distress will bring unacceptable costs, then any government or central bank will be tempted to provide support, for example by seeking new legislation that authorizes emergency bailouts.

Ms. Miller stresses the lack of potential future “taxpayer support” — and that is an appropriate point for a Treasury official to make. But sophisticated modern central bankers have many ways to provide help to troubled financial institutions (e.g., through various kinds of asset-purchase programs), while complying with the letter of Dodd-Frank. To assert otherwise is to create the wrong impression.

Second, Ms. Miller claims that “some evidence actually suggests the opposite conclusion — that larger banks’ funding costs are higher than those of their smaller peers” (see Page 2). The Treasury’s evidence on this point is embarrassingly naïve; it compares funding costs irrespective of the source (see Page 11). A small bank funded mostly with insured deposits will have a lower funding cost than a bank that relies more on wholesale funding. But this difference does not speak to the issue of too-big-to-fail implicit subsidies.

The right comparison is what large banks are paying compared with what they would pay if they did not have implicit government backing.

Banks used to be good at measuring this kind of implicit government support, when it provided an unfair competitive advantage to Fannie Mae and Freddie Mac. Now that they (the private megabanks) are the recipients of this largess, they have become much hazier on methodology — asserting that everything anyone tries to measure is awfully complicated.

In a speech at the International Monetary Fund last week, Jeremy Stein, a Federal Reserve governor, acknowledged that too big to fail is not over: “We’re not yet at a point where we should be satisfied,” he said in the third paragraph. The Fed chairman, Ben Bernanke, has recently made the same point. It’s interesting that Treasury should want to confront the Fed on this relatively technical point. This is exactly the kind of issue on which the Fed usually has better information and analysis, and in the current iteration the Fed also seems to have a distinct edge.

Third, Ms. Miller insists that “the evidence on both sides of the argument is mixed and complicated” because of the many factors besides too big to fail that could be the cause of the funding advantage. But isn’t this why we elevate Treasury appointees to such a high position in the pantheon of our officials, because they are supposed to be able to sort out complex issues?

Where is the Office of Financial Research, a unit created within Treasury by Dodd-Frank, on this issue? In her reluctance to take sides or state a clear position, Ms. Miller appears to be ducking (Pages 3-4). This is a disappointing performance by an experienced and well-informed official.

In fact, there is a long list of studies that find various ways to take into account all of the complicating factors and isolate the too-big-to-fail subsidy. None of these are cited by Ms. Miller, but taken together, the conclusion is clear — the implicit subsidy is large and still with us.

One example is a study by Profs. Viral Acharya of New York University, Deniz Anginer of Virginia Tech and A. Joseph Warburton of Syracuse (released on Jan. 1) that measures the funding cost advantage provided by implicit government support to large financial institutions, while controlling for other factors. Credit spreads were lower (because of implicit guarantees) by approximately 28 basis points on average over the 1990-2010 period — with a peak of more than 120 basis points in 2009 (when having access to this subsidy really mattered). In 2010, the last year of the study, the implicit subsidy this provided to the largest banks was worth nearly $100 billion. The authors conclude, “Passage of Dodd-Frank did not eliminate expectations of government support.”

If Ms. Miller contests the methodology or results of this (or any other) study or regards the numbers as insufficiently current, she should request that the Office of Financial Research, the Fed or any other competent government body devise better methodology on the latest available data (or even use the real-time data available to supervisors). The United States government has many smart people, the best available data and the undoubted ability to conduct sensible econometric work (with full disclosure). Five years after the onset of the worst financial crisis since the Great Depression, we should expect nothing less from the Treasury Department.

Fourth, Ms. Miller is very taken with the fact that credit rating agencies have reduced the “uplift” they determine is due to government support for megabanks — i.e., they assign a lower probability of default (and losses for creditors) because there is some form of official backstop. And she makes a great deal of Moody’s saying that it may eliminate uplift altogether. We can debate for a long time about the value of credit-rating-agency opinions, but the striking fact about Ms. Miller’s reference to Moody’s is that it exactly contradicts her on the current situation (see Moody’s report). Moody’s still has a significant too-big-to-fail uplift for big banks.

Fifth, Ms. Miller is adamant that if too big to fail were a problem, we would see low credit-default-swap spreads across the board (for megabanks). But the figure to which she refers (see Page 10) is not persuasive. Look at the pattern of credit-default-swap spreads at the height of the crisis, when the doctrine of too big to fail was undeniably in effect; it is very similar to what we see today. Or hide the date and try to find the magic moment when Dodd-Frank supposedly changed the bailout game.

Sixth, Ms. Miller points out that credit-default-swap spreads have declined since the crisis. That is correct. But all that tells you is that we are not currently in a crisis phase. The real question is what happens the next time large financial institutions mismanage their risks and bring us to the brink of disaster.

Seventh, Ms. Miller asserts that capital requirements have increased “significantly” since the crisis (Page 4). But notice the complete absence of numbers in this part of her speech. How high are minimum capital requirements under Basel III? They are low — a bank could fund itself with 97 percent debt and 3 percent equity and still comply with the rules (see Section 4 in this handy Accenture guide to Basel III, Page 32). In this context, global megabank is a fancy name for a high-risk hedge fund, albeit one with access to the government-sponsored safety net.

Eighth, Ms. Miller points out that banks now have more capital on their balance sheets than they did four years ago (meaning they are funded with more equity relative to debt). This is correct, but it is a completely standard reaction among corporate survivors of financial crises. They are more cautious, for a while. But then they start to push up their return on equity, unadjusted for risk; this is the basis for executive and trader compensation, after all. And the best way to do this is to borrow more heavily, increasing leverage and reducing equity funding relative to their balance sheets (an equivalent way of saying that they borrow more and rely less on equity — in banking jargon, they reduce their capital levels).

It is alarming that Ms. Miller demonstrates no awareness of this well-established historical pattern — or the ingrained incentives in the financial system that make overleveraging hard to avoid.

Over all, Ms. Miller’s speech is completely unconvincing on the substance of the points that she is trying to make. Dodd-Frank alone will not end too big to fail.

It makes sense that senior Treasury officials should want to put Dodd-Frank into effect. But it is disconcerting when they are unable to confront the market and political realities of too-big-to-fail banks. Any such level of denial will not serve us well.