09/27/2011 05:11 pm ET Updated Nov 27, 2011

Too Big to Fail: Timing Is (Still) Everything

The federal government's efforts to avert a cataclysmic failure of the financial markets in the fall of 2008 formed the basis for intense drama -- in real life and on the big screen -- and served as the catalyst for a host of provisions of the Dodd-Frank Act. One of these shares the name of the movie that played out that drama -- Too Big To Fail. The concept of "too big to fail" has been around for some time in the banking industry; Dodd-Frank expands it to other nonbank financial firms, as well as firms that support the financial markets, so-called "financial market utilities," or FMUs.

Fast forward to 2011 and "too big to fail" continues to dominate headlines, including an intense debate over whether Dodd-Frank has resolved the issue of "too big to fail." Certainly, there are numerous provisions in Dodd-Frank focused squarely on ending "too big to fail." These include new authorities extended to the Federal Deposit Insurance Corporation to resolve financially distressed bank and nonbank systemically important financial institution, or "SIFIs;" a requirement that SIFIs structure and file with regulators rapid resolution plans, or "living wills," to wind down their operations in the event of financial distress; enhanced supervision and prudential standards imposed on certain nonbank financial companies and bank holding companies; and higher capital standards for the largest and most systemically significant bank holding companies. In addition, Dodd-Frank addresses the issue of systemic risk, the foundation upon which "too big to fail" is built, by providing for oversight and supervision of FMUs that form the backbone of the financial markets.

The objective of minimizing systemic risk pervades Dodd-Frank through provisions directed at limiting or curtailing certain activities viewed as risky, and incorporating various systemic changes to reduce system-wide risks. Certainly, reducing, minimizing and controlling risk to our financial system is critically important, but at what cost? Is there a point at which the burden of regulation actually begins to undermine the very purpose for which it is designed?

While we can debate this issue and whether or not "too big to fail" has been eliminated, the fact remains that we really do not know, nor can we predict with any reasonable degree of certainty what could happen with the meltdown of a very large or very interconnected SIFI or FMU. Equally confounding is trying to predict the impact on a SIFI or a number of SIFIs of the catastrophic failure of one or more large foreign financial firms (even though such firms are subject to significant oversight pursuant to Dodd-Frank) ... or countries. Like it or not, we live in a highly globalized world that provides significant benefits but poses serious risks to our financial system. There is no way to know for sure what will happen if certain firms and/or market segments get into serious financial distress, nor the broader systemic impact of such troubles. That was the stark lesson of 2008. Another lesson was that even the largest financial firms can - and do - fail, so apparently too big to fail was not a show-stopper even then.

The reality is that the federal government will intervene to save a failing financial firm if the consequences of its failure could pose systemic risk - and this is what we should want. If propping up a failing financial firm will avert the likely possibility of a broader systemic meltdown, then by all means we should have a way to avoid disaster. The difficulty is in preserving the integrity of a system that rewards responsible risk-taking and a healthy profit motive while punishing excessive risks that could shift losses from a SIFI to the taxpayer. This is a balance that is very important to the success of Dodd-Frank, and one that appears to be under fire not because Dodd-Frank is wrong but because the speed and timing of its proposed reforms.

We are not very far from the temporal epicenter of the financial crisis and, yet, we are attempting rapidly to deploy a host of well-intended but perhaps significantly too soon (and costly) regulatory reforms that naturally are causing those impacted by the changes to pull back. While the wisdom of increased capital standards for the largest banks can be debated, raising capital standards at the very time that increased lending is needed appears to be counter-productive. Certainly, we should not be encouraging excessive leveraging, but we may want to avoid imposing higher capital standards that will curtail lending at the very time it is desperately needed for job creation. Similarly, requiring banks to spend tens of millions of dollars on new compliance programs to track and implement regulatory reforms rather than exploring ways gradually to implement reforms as economic conditions improve seems counterproductive. This phenomenon is most acute when we consider the host of requirements imposed on SIFIs, the institutions we need to lead us out of the current economic downturn. This is not to suggest that many of these reforms are not needed or not helpful, only that the aggregate impact and timing may be causing more harm than good at the moment.

Tackling "too big to fail" and finding ways to minimize systemic risk are issues that we can get to in time ... for now, the best course of action may be continuing thoughtfully and incrementally to pursue reforms that strengthen our financial system by restoring consumer confidence and increasing lending. While exactly what will work and why is subject to debate, regardless of the answer, time is needed for regulators to be able to implement reforms and make adjustments based on what works and what is not effective. Similarly, time is needed for the financial sector to recover from the financial crisis and to implement the reforms that will keep us from the next financial disaster. In implementing regulatory reforms, whether to resolve "too big to fail," minimize systemic risk, or address the multitude of other issues raised in Dodd- Frank, balance and perspective are critical and, in that regard, timing is everything.

Kevin L. Petrasic is a partner in the Paul Hastings Global Banking practice, resident in the Washington, D.C. office. He advises banks and financial services firms on a wide array of regulatory, legislative, transactional and compliance issues.