The advantage of being seen as "too big to fail"

Kansas City Federal Reserve President Thomas Hoenig provided interesting testimony concerning the too big to fail phenomenon at a House Subcommittee on Oversight and Investigations hearing held yesterday in Overland Park, Kansas.  Hoenig pointed out that the expectation that the largest banks will be protected from failure gives them a significant competitive advantage.  The basis for that advantage has been a lower cost of capital and the ability to use greater leverage.  Hoenig's testimony included an emphasis on the economic importance of community banks.  He noted that the 'community bank model has held up well when compared with the megabank model that had to be propped up with taxpayer funding.'   The Dodd-Frank Wall Street Reform and Consumer Protection Act (the 'Act') contains some provisions that address the issue, but the Act may do little in the immediate future to reduce the competitive advantage enjoyed by the largest banks.  As Hoenig's testimony points out, these advantages may persist until investors are convinced that things really have changed.  But what will it take to change those investor expectations?  Such a change in investor perceptions may not take place for several years, if at all.  Many provisions of the Act will take a long time to fully implement, and some provisions are subject to a considerable degree of regulatory discretion. It seems probable that the memory of the shock to the financial system associated with the 2008 failure of Lehman Brothers Holdings Inc. will make regulators reluctant to risk a repetition of such an event.  Many investors may conclude that provisions of the Act that would create a more level playing field between large banks and community banks will have 'more bark than bite' in reality.  It may be difficult to convince investors that risk must be taken more seriously and that investors cannot count on some form of government rescue package when things go wrong.  In the meantime, community banks can expect to continue to face a challenging competitive environment.