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For U.S. banks, bigger is still better despite the financial reform law’s attempt to rein in “too big to fail” institutions, a government watchdog says.

An analysis of Citigroup’s $20 billion government rescue in 2008 shows that “unless and until institutions like Citigroup can be left to suffer the full consequences of their own folly, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous results,” Neil Barofsky, the Special Inspector General for the Troubled Asset Relief Program (SIGTARP), said in a 77-page report released today.

“The market still gives the largest financial institutions an advantage over their smaller counterparts by enabling them to raise funds more cheaply, and enjoy enhanced credit ratings based on the assumption that the government remains as a backstop,” the report said. And top executives at banks that are too big to fail may take greater risks than they otherwise would, it said.

The Financial Stability Oversight Council, created by the Dodd-Frank financial reform law, is developing criteria to assess the systemic significance of big banks and other financial services companies. The law also gave the Federal Deposit Insurance Corp. new resolution authority for companies that are deemed systemically significant.

But it remains to be seen whether the reform law will address the so-called moral hazard created when big banks know the federal government won’t allow them to fail because of their size and interconnectedness to the global financial system, the SIGTARP report said.

Treasury Secretary Timothy Geithner told SIGTARP that creating purely objective criteria to evaluate systemic risk is not possible, saying “it depends too much on the state of the world at the time. You won’t be able to make a judgment about what’s systemic and what’s not until you know the nature of the shock” the economy is undergoing. He also said that whatever objective criteria were developed in advance, markets and institutions would adjust and “migrate around them,” the report said.

In the Citigroup bailout, the Treasury Department imposed strict terms on the bank and received preferred shares in exchange for the injection of $20 billion in taxpayer money. Saving the bank proved to be the right decision, the watchdog said, even though it was based “on gut instinct and the fear of the unknown.”

Since the financial markets crisis of 2008-09, U.S. banks have continued to consolidate and grow larger.

For example, JPMorgan Chase & Co. now controls about 46 percent of all U.S. bank deposits and has $2 trillion in assets. Citigroup and Bank of America Corp. each also have about $2 trillion in assets, followed by Wells Fargo & Co. with $1 trillion, Goldman Sachs with $880 million, and Morgan Stanley with $820 million.

Together the six largest U.S. banks’ assets were worth about 64 percent of GDP at the end of the 2010 third quarter, according to economist Simon Johnson. That’s a jump from 2006, when the same institutions held about 55 percent of GDP, and a huge leap from 1995, when the group – some with different names at that time – held just 17 percent of GDP, he says.

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