With Banks In Texas, Small Is Beautiful

As we await the first designations from the FSOC, a small bank in Texas is reminding us just how empty Dodd-Frank's promises of ending too-big-to-fail are.

This article was originally published in Real Clear Markets

A brave bank filed a lawsuit last week in federal district court that challenged Dodd-Frank on constitutional grounds. Specifically, the suit targets two new Dodd-Frank creations -- the Consumer Financial Protection Bureau and the Financial Stability Oversight Council. The challenge against the CFPB is likely to draw a lot of public attention, because the CFPB's constitutional flaws have been noted from its inception. Nevertheless, the challenge against FSOC is important too, because it highlights Dodd-Frank's tendency to skew the marketplace in favor of big institutions.

State National Bank of Big Spring, the lead plaintiff in this case, is a small Texas bank. Had it not filed suit, it is unlikely the FSOC would have paid much attention to it. The FSOC is too preoccupied with identifying nonbank financial companies that "could pose a threat to the financial stability of the United States." The threat could come from the effect the company's financial distress would have or "the nature, scope, size, scale, concentration, interconnectedness, or mix of [its] activities." With a 2/3 vote, the ten voting members of the FSOC -- all the heads of the federal financial regulators and an insurance expert -- can designate any nonbank financial company to be systemically dangerous.

A company that gets designated will be regulated by the Federal Reserve, which will not be a pleasant or cheap ordeal. Those costs are likely to be particularly high initially, since the Fed does not have much experience regulating nonbank financial companies and is likely to try to regulate them just like banks, which they are, by definition, not. Nobody wants to be the guinea pig as the Fed tries to apply its bank-centric regulatory model to insurance companies or asset managers.

But, as the bank's legal challenge explains, "the costs of a ‘systemic importance' designation are outweighed by its benefits." Being designated by FSOC is like getting a "too-big-to-fail" sign affixed to your forehead. Anyone who is looking for an entity to do business with will be drawn to that sign, because it is a strong indicator of future government support. In practice, "too-big-to-fail" often means "too-big-to-let-your-bills-to-your-creditors-go-unpaid-so-Uncle-Sam-will-pay-them-for-you-when-you-get-in-trouble." Accordingly, an entity that gets designated in this manner will have a funding advantage over its rivals.

Under Dodd-Frank, the designated entity can appeal the FSOC's determination to the FSOC (unless the FSOC decides not to allow such an appeal). If that appeal fails, the entity can go to court for a limited review of the FSOC's decision. Tactically, it might be wise for a designated company to appeal to the court; once the FSOC makes its final determination, everybody will know regulators think the company is too-big-to-fail. If the company can avoid the regulatory costs associated with the designation through a successful court challenge, then it gets the best of both worlds.

Competitors of the designated entities will not have an opportunity to object at any point throughout the process. Nor will taxpayers, for that matter. Dodd-Frank doesn't recognize the harmful effects the designation could have on competitors or taxpayers.

As we await the first designations from the FSOC, a small bank in Texas is reminding us just how empty Dodd-Frank's promises of ending too-big-to-fail are.