During the financial crisis, the big got bigger.
But over the next handful of years, the giants may become smaller, simpler and safer as regulators use tools provided in the Dodd-Frank Act to make it expensive and inconvenient to be big and complex.
This is not the conventional wisdom. After the bloodbath that was Lehman Brothers, most people believe the government will always cave in a crisis.
When large financial firms get into trouble, "the political authorities will blink and will bail them out," the Nobel Prize-winning economist Joseph E. Stiglitz said at a recent conference hosted by Financial Times. "There is no doubt about that."
That may be because the debate over "too big to fail" is still mostly talk. And not terribly convincing talk at that.
Take the Treasury Department's release announcing the Financial Stability Oversight Council's first meeting this month. It made a point of noting that the council's mandate goes beyond identifying threats and responding to emerging risks to the financial system.
The council is also charged with "eliminating expectations on the part of shareholders, creditors and counterparties that the government will shield them from losses in the event of failure," Secretary Tim Geithner said.
This "no more bailouts" line is also being trumpeted by Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair.
But "too big to fail" has underpinned the financial system for a long time. Much the way that deposit insurance gives retail customers confidence in banks, knowing that the government will step in a systemic emergency is what allows modern banking to exist. And few industry observers expect that to change.
But there are some people, mostly regulators, who believe — or at least hope — Dodd-Frank is the answer to "too big to fail."
Ron Feldman of the Federal Reserve Bank of Minneapolis has spent his career arguing against big-bank bailouts.
The senior vice president for supervision, regulation and credit, along with his former boss, Gary Stern, wrote a book a few years back prescribing ways to end "too big to fail."
Feldman is not an easy person to convince that the "too big to fail" era is over, and yet he views Dodd-Frank as nearly perfect on this front.
"I can't think of any serious idea other than taxation that is not in the bill," Feldman said in an interview. "I don't think there is any serious reform that is not in the bill or we don't have the power in the bill to then implement later. That is pretty remarkable."
The reform law did not mandate that large financial firms be broken apart, as some had advocated. Instead it uses a belt-and-suspenders approach that may make being large simply not worth the cost or effort.
For example, under Dodd-Frank, any financial firm can be designated as "systemically important" and subjected to close scrutiny by the Fed. So long shadow banking system.
And any firm tagged "systemically important" will face higher capital and liquidity requirements as well as "credit exposure requirements, concentration limits, contingent capital requirements, enhanced public disclosures, short-term debt limits, and risk management requirements," according to the law.
Dodd-Frank also extended the "prompt corrective action" policy to holding companies for the first time; as a company's capital declines regulators will be able to bar dividend payments, block acquisitions or restrict growth. When things get really bad, regulators will be able to limit transactions with affiliates, force asset sales or even remove management.
Any company deemed to pose a grave threat to financial stability also could face constraints on its leverage.
As one senior regulator in Washington put it, "Once you get this [systemically important] designation, you fall into a world where you are going to be feeling a lot more supervisory intensity."
The law also gave the FDIC the authority to resolve any failing financial firm. The law forbids a conservatorship; the FDIC must close the firm and unwind it. To assist with this, the FDIC and the Fed will require big firms to design "living wills," or road maps for their resolution in the event of failure.
Shareholders and long-term debtholders will be wiped out; there is some wiggle room for short-term creditors, but the law bars even these investors from being repaid more than they would get in a bankruptcy.
New clearing houses will bring transparency to the murky derivatives market; netting will reduce total exposure and it will be easier to figure out who owes what to whom.
Feldman says — and he is backed up by other supervisors, who preferred to remain anonymous — that if Dodd-Frank is implemented effectively, large financial companies will voluntarily choose to downsize because their funding costs will increase as creditors realize they will not be protected in a failure.
"If we get this right and we get rid of the subsidy they have, they are going to figure out whether they need to get smaller," he said. "Maybe they will hold more capital, maybe they are going to make themselves simpler, maybe they will just sell assets, or maybe they will just take on less risk. … I don't know which one it's going to be, but that will be the sign" of whether the regulators have done their jobs.
"Two or three years out, if we don't see some of that then something is not working right," Feldman said.
Another regulator is blunter.
"The cost of credit to those firms that have benefited from 'too big to fail' historically is going up, and in relative terms they are going to be smaller. It's a logical implication — and not a bad one."
To be sure, it remains to be seen whether Dodd-Frank will be implemented effectively. And there are critics who dismiss officials like Feldman as theorists, detached from real-world pressures.
Two former regulators said Dodd-Frank does nothing to stop the one thing most likely to fell a large bank — a run. And they suspect regulators will do whatever they must to stop runs, including bailing out big banks.
"If you have a run, none of these other apparatuses the bill put in place work. They don't have time to work," one of the former regulators told me. "What you are saying is if they work right, you will never have another run. And nobody believes that."
Not nobody. Feldman believes. But he stressed it will only work if creditors also believe, and that will only happen when it's clear who stands to lose money.
"We are going to need to be as transparent as we possibly can," Feldman said. "Once we do that, creditors will look at that and say, 'Hmm, this does seem like a different world.' "
The other regulator again was more blunt.
Noting that Congress has clearly said there should be no more bailouts of "too-big" firms, he said: "Most people in government are probably like me and they would say, 'The law says you can't do this.' And I am not going to jail."
Barb Rehm is American Banker's editor at large. She welcomes feedback to her weekly column at Barbara.Rehm@SourceMedia.com.