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New bank meme: Too connected to fail

October 28, 2013: 5:00 AM ET

Two new studies find preferential treatment for banks with political ties to the Treasury Department.

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FORTUNE -- Move over "too big." There's a new knock on the mega banks: "Too connected to fail."

Two studies published in the past few weeks tackle the issue of whether big banks get special privileges because of their connections to top regulators and Washington officials.

Both studies focus on the early days of the financial crisis. The first, titled "The Value of Connections in Turbulent Times," came last month from a group of five economists including MIT's Simon Johnson, who has been a vocal proponent of breaking up the big banks. The Johnson study finds that shares of banks with stronger connections to Timothy Geithner rose 11.2% more than those that didn't after news was leaked back in 2008 that Geithner was to become Treasury Secretary. Remember, this was at the height of the financial crisis, when the possibility that the government would have to nationalize a number of banks, or all of them, was thought of as a real thing. The rise in stock prices could mean that investors thought that banks with better ties to a key Washington insider had a better chance of surviving the financial crisis intact, or at least getting better treatment.

MORE: Bank of America's legal loss could spell doom for other banks

The second study arrived earlier last week and focuses on the Federal Reserve and the loans it made to banks in 2007 and 2008. The study, by George Mason University economics professor Benjamin Blau, finds that banks receiving emergency loans spent significantly more --72 times as much -- on lobbying in the decade prior to the financial crisis than those that didn't get assistance. What's more, even after Blau adjusted for size, he found that banks with political connections got bigger loans than those that didn't.

This, of course, feels unfair. But it may not be all that surprising. Banks that deal in complex markets are often more likely to have stronger ties to regulators, who are making the rules. And since the financial crisis, in part, erupted because of the complexity of those markets, it makes sense that the banks that needed the most assistance were the ones that spent the most time with regulators.

The cynical way to interpret this data is that banks hire lobbyists and connected individuals in order to skirt the rules so that they can make risky bets that boost profits and bonuses in good times. In bad times, their connections lead to government bailouts on favorable terms, also boosting bonuses.

But that may not be exactly what's going on here. First, the Johnson study is only measuring perception, and the market could be getting this wrong. One of the biggest beneficiaries of the financial crisis was Wells Fargo (WFC). It was able to buy Wachovia and get huge tax breaks for doing so. And it also used the financial crisis to extend its dominance of the mortgage market. The Johnson study does show that Wells' stock did react positively to Geithner's appointment, but not nearly as much as Citigroup (C), which is still struggling post-financial crisis. Although, I guess, you could argue that without Geithner it would have been even worse.

MORE: By every measure, the big banks are even bigger

The Johnson study didn't find any ties between Geithner and AIG (AIG). Yet Geithner was key in providing assistance to the large insurer. Johnson and Co. chalks that up to the fact that AIG was essentially a backdoor bailout for the big banks, but that doesn't really explain why Geithner defended paying bonuses to key AIG employees even after the firm -- and, by extension, the banks -- were bailed out.

To their credit, both studies point out that there could be something less nefarious going on here. The most benign comes from the Blau study that says banks that lobby were probably more likely to seek out Fed loans. But, in general, the studies claim that it is likely that Geithner and the Fed handed out assistance to the firms that they knew best. And if you are handing out taxpayer money and you hope to get it back, going with firms you know probably isn't a bad choice. But it's not as if all the spending on behalf of the banks has been free of misguided, or even corrupt, motivations and processes.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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