Getting Rid Of ‘Too Big To Fail’ – Part II

13462_0aa96pic Getting Rid Of 'Too Big To Fail' - Part II REQUIRED READING: It seems to me that efforts by U.S. and global regulators to fight ‘too big to fail’ are generally on the right track. The Basel III and Dodd-Frank reforms designed to reduce the probability of failure of large banking firms are sensible and, for the most part, targeted at the causes of the crisis. They are being implemented thoughtfully and effectively. And I believe that those Financial Stability Board and Dodd-Frank reforms designed to permit the resolution of systemic firms without taxpayer exposure or undue disruption are very promising.

That said, much of the work lies ahead. The critics also deserve a fair hearing.Â

Some of the criticism argues that the Dodd-Frank Act – particularly the Orderly Liquidation Authority (OLA) mechanism – enshrines taxpayer bailouts. I do not believe that it does. OLA requires by its terms that the losses of any financial company placed into Federal Deposit Insurance Corp. (FDIC) receivership be borne by the private sector stockholders and creditors of the firm. Single-point-of-entry can work without exposing taxpayers to loss.Â

Although the FDIC has authority to provide temporary liquidity to a failed firm, any costs incurred by the FDIC in resolving the firm must be recovered completely from either the assets of the firm or assessments on the financial industry. The failed firm's investors – and, if necessary, other large financial firms – will bear any costs. That is ‘bail-in,’ not ‘bailout.’

Another strand of criticism argues that reforms do not go far enough and calls for more activity limits on banking firms, for limiting their size or systemic footprint, or for simply breaking them up. Some have urged the resurrection of the 1930s-era Glass-Steagall prohibitions – that is, preventing the affiliation of commercial banks with investment banks. This proposal seems neither directly related to the causes of the financial crisis, nor likely to help end "too big to fail."

The systemic run that led to the financial crisis began with traditional investment banks, such as Bear Stearns and Lehman Brothers. The activities of these firms were, of course, not affected by the repeal of Glass-Steagall. Commercial banking firms now engage in activities traditionally associated with investment banking, such as securities underwriting. The combination of these activities under a single corporate umbrella did not contribute meaningfully to the financial crisis.

In my view, losses at the commercial banks were more importantly a consequence of bad credit underwriting and the failure of risk management systems to keep up with innovation and the explosive growth in securitization – developments that were not fundamentally driven by the repeal of Glass-Steagall.

There are also calls to further limit the size or systemic footprint of financial firms. Limits of this nature require, and deserve, careful analysis.Â

Two provisions of existing law already impose size caps on U.S. banking firms. One limits acquisitions of banks by any bank holding company that controls more than 10% of the total insured deposits in the U.S., and a second, added by Dodd-Frank, forbids acquisitions by any financial firm that controls more than 10% of the total liabilities of U.S. financial firms. In addition, Dodd-Frank added a new requirement that banking regulators consider ‘risk to the stability of the U.S. banking or financial system’ in evaluating any proposed merger or acquisition by a bank or bank holding company.

Critics argue that these restrictions are inadequate and subject to exceptions that continue to allow even the largest firms to grow, both organically and through acquisitions. The simplest forms of this idea would put a further absolute limit on the amount of balance sheet assets or liabilities, or on the risk-weighted assets of a financial firm.

Capping the size or systemic footprint of each financial firm would limit the adverse systemic effects of the failure of any single firm. Smaller, simpler financial firms should be easier to manage and supervise in life, and easier to resolve in death.

One option would be to impose a cap on a large U.S. banking firm's short-term non-deposit liabilities as a fraction of U.S. gross domestic product. This form of proposal would allow such a firm to continue to increase assets and diversify its activities to achieve potentially available economies of scale and scope, so long as the firm finances expansion through more stable forms of funding.

Any new size limits should be designed to limit the systemic footprint while minimizing costs to efficiency. This will be a challenging task. The question of whether the benefits of further size limits would exceed any losses in scale economies and other efficiencies is the subject of ongoing research and debate.

Break it up

Some critics want to get right to the business of breaking up the big banks into smaller, more manageable, more easily resolvable pieces. At the heart of this proposal is the thought that no financial institution should be so large or complex that it cannot be allowed to fail, like any other private business, with losses to its equity holders and creditors, and consequences for senior management. If the largest institutions were too big to fail during the financial crisis, why not make them smaller?

Today, the market still appears to provide a subsidy to very large banks to account for the possibility of a government bailout in the event of failure. This subsidy, in the form of lower funding costs, may encourage ‘too-bigness.’ There would be substantial externalities to a large bank failure as well.Â

The market needs to believe – and it needs to be the case – that every private financial institution can fail and be resolved under our laws without imposing undue costs on society. The current reform agenda is designed to accomplish just that, through two channels.

First, it is intended to substantially reduce the likelihood of failure through a broad range of stronger regulation, including higher capital and liquidity standards, stress tests and recovery planning, among other reforms. Second, it is intended to minimize the externalities from failure by making it possible to resolve a large financial institution without taxpayer exposure and without uncontainable disruption. If these reforms achieve their purpose, in my view they would be preferable to a government-imposed break-up, which would likely involve arbitrary judgments, efficiency losses and a difficult transition.Â

Today, few ideas can be less controversial than ending ‘too big to fail.’ The question is ‘How?’ – and there are differing opinions on that. In Titles I and II of Dodd-Frank, Congress has given the regulators a game plan for ending ‘too big to fail.’ The regulators, including the Federal Reserve, are forcefully implementing the plan we have been given. Â

My own view is that the framework of current reforms is promising, and should be given time to work. In any case, ‘too big to fail’ must end, even if more intrusive measures prove necessary in the end.

Jerome H. Powell is a governor of the Federal Reserve Board. This article is adapted and edited from a March 4 speech delivered at the Institute of International Bankers 2013 Washington Conference. The original text is online.


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