In the parlance of credit rating agencies, it is all about "notches." These pesky merits and demerits determine how much a company must pay for its debt. Even though the lords of credit ratings have been humiliated, their scorecard is still the official one.

It is remarkable that after years of Washington's wrangling about "too big to fail," it all comes down to notches. The political class is falling all over itself claiming that its version of financial reform legislation will eliminate the TBTF problem.

What the politicians fail to recognize is that providing liquidity to the financial system in times of stress is an essential part of every central banker's toolbox. The financial system cannot function without it.

Moreover, it is unthinkable that any government would allow its five largest banks to begin toppling when they control more than half of the financial system.

The firms that benefit from the TBTF policy, if unrestrained, contribute to the very stress the financial system is currently experiencing. Think of Fannie Mae and Freddie Mac without the patina of a social mission and you have Goldman Sachs.

Andrew Haldane, executive director for financial stability at the Bank of England, does an excellent job of explaining how credit rating notches translate into a windfall for TBTF banks. The notches that Haldane describes are awarded to global banks solely due to the implicit pledge that their creditors will be bailed out.

How do two or three notches translate into dollars? Try $220 billion for 2008 and $250 billion for 2009!

A bank becomes "too big to fail" for two principal reasons. Generally, the larger a bank, the larger its executive compensation. Moreover, by being perceived as TBTF, banks receive a subsidy in the cost of their debt — a credit enhancement courtesy of the taxpayers.

We know that there are no economies of scale for banks once they hit the $100 billion asset threshold. Similarly, we know that any economies of scope are more than offset by increased risks and monitoring costs.

Calls to break up the banks are so much hot air. These calls make for great press releases, but the political will to pull it off does not exist. Just last week, the Swiss proclaimed that their two big banks, UBS and Credit Suisse, are and will remain TBTF. What U.S. bureaucrat is going to initiate unilateral disarmament by domestic banks?

There are many parallels between the congressional debate over health insurance reform and the debate over financial regulatory reform. One glaring difference, however, is that, in the case of health care, the verdict will be years in coming, while the verdict about TBTF reform will be immediate.

The verdict will come in the form of "notches." Once it becomes obvious that legislation is to become law, keep an eye on the credit raters' reactions. If the pledge to end TBTF is taken seriously, one would expect to see a dramatic narrowing of the spread between TBTF debt and the debt of non-TBTF financial institutions.

If that spread remains unchanged or widens, then we will know for certain that the capital markets have seen through the political charade. Nothing will change, and the next crisis will be only a matter of time.

And just in case you have lost all confidence in the diktats of the credit rating agencies, here is another measure to watch. Look at the cost of insuring $10 million of megabank debt against default in the post-reform market. That cost should rise materially upon removal of the safety net, but don't bet the ranch on its happening.

Members of Congress who plan on claiming victory over TBTF as part of their re-election campaigns this fall may want to have a backup strategy in case the verdict on their handiwork rendered by the credit raters and the credit-default swaps market goes against them.

It is time we began talking about an alternative approach to TBTF — one that would remove the incentives to become "too big to fail" in the first instance. Removing all or part of the "too big to fail" subsidy is a good place to start.

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