Too-big-to-fail banks distort the market: Investors are more willing to lend them money, because they know that the government will bail them out in a pinch.
What's more, the TBTF banks make profits in good times, and get government bailouts when times get really rough. Besides being fundamentally unfair, that gives officials at the big banks an incentive to take more risks.
So it's not surprising that backers of last year's big Dodd-Frank bill said it would end the problem — not by breaking up big banks, but by giving regulators new power to "dismember" failing banks, no matter how big.
But, according to today's testimony from a government watchdog, investors and rating agencies don't believe it: They think the biggest banks are still too big to fail.
In his prepared testimony before a House committee today, TARP inspector general Neil Barofsky says that investors are still lending money to big banks on the cheap:
The largest institutions continue to enjoy access to cheaper credit based on the existence of the implicit Government guarantee against failure.
What's more, Barofsky points to S&P's plan to change the way it rates the biggest banks, to explicitly take into account the likelihood of government bailouts. He quotes this sentence from a recent S&P report:
We believe that banking crises will happen again. We expect this pattern of banking sector boom and bust and government support to repeat itself in some fashion, regardless of governments' recent and emerging policy response.
In short, S&P is telling the market that it does not believe that the Dodd-Frank Act has yet ended the problems of "too big to fail," and given the discounts that such institutions continue to receive, the market seems to be listening.
For more: We reported back in April of last year that there's basically one way to get rid of too-big-to-fail: Make the biggest banks get smaller.