In a report last week, Treasury Secretary Tim Geithner noted that the Financial Stability Oversight Council will name the first "nonbank systemically important financial institutions" this year.

Under the Dodd-Frank financial-reform law, large nonbank firms may be declared systemically important because their failure will cause a systemic breakdown. In effect, this amounts to a government statement that these firms are too big to fail.

This designation will extend to virtually every segment of finance-securities firms, hedge funds, finance companies and insurers, among others-the same compromised competitive conditions that now exist in banking. The largest firms, advantaged by the same implicit government guarantee that exists for the largest banks, will have a lower cost of funds than their smaller competitors and will come to dominate every financial industry-just as the government-sponsored agencies Fannie Mae and Freddie Mac drove competitors from the housing-finance market.

Why would the Dodd-Frank Act lead to this outcome, when the legislation explicitly includes among its purposes a desire "to end 'too big to fail'"? Because of a serious misreading by the administration and Congress of what actually happened in the financial crisis.

Dodd-Frank relies on the notion that interconnections among large nonbank firms amplified the crisis-in effect, that Lehman Brothers' bankruptcy in September 2008 weakened other large financial institutions, imperiling the entire financial system. Thus, under the authority granted to it by Dodd-Frank, the Federal Reserve recently proposed limits on any systemically important nonbank firm's exposure to a counterparty-25% of regulatory capital as a general limit. This means that if regulatory capital is 10% of assets, exposure to any counterparty could not exceed 2.5% of its assets.

These limits will have a significant effect on the flexibility of these companies and the U.S. economy as a whole. The function of a financial system is to transfer funds from a place where they are not used efficiently to a place where they will be, and this is done in substantial part by interconnections-that is, by borrowing or lending-among financial institutions. If adopted, the Fed's new rule will impose bureaucratic controls and rigidities that will substitute for a firms' own risk management, affecting trading as well as lending.

If the financial crisis of 2008 was really caused or amplified by interconnections among financial firms, new rules like this might be justified.

Most observers would acknowledge that the bankruptcy of Lehman Brothers was the crisis-triggering event. Immediately after it occurred, banks and financial institutions stopped lending to one another and began to hoard cash. This frightening and unprecedented event spurred extraordinary actions by the federal government, including passage of the Troubled Asset Relief Program (TARP) and the bailout of insurance giant AIG and several commercial banks.

But there's no evidence that any of the financial institutions that were rescued-AIG, Citigroup, Wachovia, Washington Mutual, Merrill Lynch-were weakened by their exposure to Lehman. Since they weren't, the whole idea of interconnections-and thus Dodd-Frank's rationale for designating financial firms as systemically important-is called into question.

The only example of a large financial firm unable to meet its obligations because of its exposure to Lehman is the Reserve Fund. This money-market mutual fund held so much Lehman commercial paper that it "broke the buck"-that is, was unable to maintain the value of its shares at $1 each.

In the panicked circumstances of the time, this provoked a run on other similar funds. But without the surrounding financial panic, a single money-market mutual fund breaking the buck (something that's happened in the past) would not cause a run on all funds, let alone a world-wide financial panic.

What really weakened so many large financial institutions at the same time, and caused a market panic, was what is known to scholars as a "common shock"-a sudden fall in the value of a widely held asset. That asset was mortgage-backed securities and primarily those based on subprime or other risky mortgages. These began to default in unprecedented numbers when the massive 10-year housing bubble in the U.S. came to an end in 2007.

As these defaults mounted, investors fled the market for mortgage-backed securities, and their value fell nearly to zero. Then, mark-to-market accounting required financial institutions holding these assets to write down their value, creating doubt about the institutions' solvency or liquidity. That's what happened to Bear Stearns, Lehman and many others.

"Interconnectedness" was not a factor. None of these firms was weakened by its exposure to Lehman or anyone else. They were weakened by the fact that virtually all of them held-or were suspected of holding-large amounts of what the media came to call "toxic assets."

Some might argue that the government's bailouts and loan guarantees obscured the fact that many firms were severely impaired by their interconnections with Lehman. But virtually all large financial institutions repaid their TARP funds within eight months, with the approval of the Fed. And the Federal Deposit Insurance Corporation's loan guarantees for banks were intended to restore market confidence, not fill holes in bank balance sheets weakened by Lehman's failure.

The myth of interconnectedness as the cause of the financial crisis is powerful evidence that the Fed does not need and should not have the powers that Dodd-Frank conferred upon it.