Financial Reform Vindicated: Banks See Credit Scores Downgraded Due To Doubts They’ll Be Bailed Out

Yesterday, three of the nation’s biggest banks — Bank of America, Citigroup, and Wells Fargo — had their credit scores downgraded by Moody’s. And the credit rating agency’s rationale for dinging the banks’ was simple — due to the Dodd-Frank financial reform law, it is less likely that the government is going to step in and bail out a mega-bank that is in trouble:

Now, having moved beyond the depths of the crisis, Moody’s believes there is an increased possibility that the government might allow a large financial institution to fail, taking the view that contagion could be limited.

Moody’s decision to assign a negative rating outlook reflects the possibility it may further reduce its systemic support assumptions in the future as a consequence of the process set in motion by the enactment of the Dodd-Frank Act. Under the rules recently finalized by the FDIC, the orderly liquidation authority included in Dodd-Frank demonstrates a clear intent to impose losses on bondholders in the event that a systemically-important banking group (such as Citigroup) was nearing failure. If fully implemented, the provisions in Dodd-Frank could further lower systemic risk by reducing interconnectedness among large institutions and could further strengthen regulators’ abilities to resolve such firms.

Moody’s is not entirely certain that Dodd-Frank’s resolution authority — which is designed to dissolve systemically risky banks that are failing, without needing to resort to a bailout — will work, and it added that there is still a high probability that the government will rescue a failing firm. But due to Dodd-Frank, the iron perception that troubled banks will be bailed out has taken a blow.

“I am glad that Moody’s recognizes that such large institutions are not ‘too big to fail,’” said Rep. Barney Frank (D-MA), whose name graces the financial reform law. However, in recent weeks, several Republicans, including those seeking the GOP’s presidential nomination, have said that they want to repeal Dodd-Frank, resetting the regulatory system to 2007.

“Repealing that Dodd-Frank act is one of the first things that we need to do,” said Texas Gov. Rick Perry (R). “We cannot go forward with Dodd-Frank,” agreed former Utah Gov. Jon Huntsman (R). But repeal would set the financial system back to its pre-crisis status quo, ensuring that the only option when a big bank gets in trouble is shoveling in boatloads of taxpayer dollars.