Putting An End To Too-Big-To-Fail

WORD ON THE STREET: The new Financial Stability Oversight Council is directed to make recommendations to the Federal Reserve's Board of Governors ‘concerning the establishment of heightened prudential standards for risk-based capital, leverage, liquidity, contingent capital, resolution plans and credit exposure reports, concentration limits, enhanced public disclosures and overall risk management’ for systemically important institutions.

The name of the game, here, is regulatory discretion. There are – as there always are – criticisms. Some feel, for instance, that while regulators are being given more authority, they are also being given ambiguous, if not conflicting, directives that would leave the specter of too-big-to-fail (TBTF) lurking in the background.

For instance, the Dodd-Frank Act states that it seeks ‘to provide the necessary authority to liquidate failing financial companies that pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.’ It also directs the Federal Deposit Insurance Corp. (FDIC) to ‘ensure that the shareholders of a covered financial company do not receive payment until after all other claims â�¦ are fully paid.’

However, the bill goes on to state that in the disposition of assets, the FDIC shall, ‘to the greatest extent practicable, conduct its operations in a manner that â�¦ mitigates the potential for serious adverse effects to the financial system.’

Language that includes a ‘desire’ to minimize moral hazard – and directs the FDIC as receiver to consider ‘the potential for serious adverse effects’ – provides wiggle room to perpetuate TBTF.

Criticisms aside, this is the path our legislative powers have laid out for dealing with the issue of TBTF. Regulators must now decide exactly how they will travel down that path.

There appear to be three major ways to navigate proposed policy-making toward big banks: (1) the regulate 'em camp, (2) the resolve 'em camp and (3) the shrink 'em camp. Let's examine these one by one.

Regulate 'em

First, we have the ‘regulate 'em’ camp. While it is certainly true that ineffective regulation of systemically important institutions such as big commercial banking companies contributed to the crisis, I find it highly unlikely that such institutions can be effectively regulated, even after reform.

To be blunt: Simple regulatory changes, in most cases, represent a too-late attempt to catch up with the tricks those being regulated – the trickiest of whom tend to be large. In the U.S. financial system, what passed as innovation was, in large part, circumvention, as financial engineers invented ways to get around the rules of the road. There is little evidence that new regulations involving capital and liquidity rules, could ever contain the circumvention instinct.

The history of regulatory capital requirements is not a distinguished one. In 1864, the National Bank Act set minimum capital requirements, but these attempts at quantifying capital adequacy were unsuccessful. Over the years, such efforts continued at both the state and federal level but without much success.

By the 1950s, it was concluded that static capital requirements could only interfere with the more comprehensive analyses required to obtain a complete picture of a bank's ability to absorb losses. In 1981, the federal banking agencies responded to diminishing bank capital positions by introducing numerical capital requirements, as the judgment-based approach to capital regulation had proven insufficient. But before long, authorities felt the need to revise these new numerical requirements, as they failed to differentiate between banks according to risk and invited capital arbitrage.

In 1988, the central banks of the G-10 adopted risk-based capital requirements, as embodied in the Basel Accord. It did not take long before the need for change was felt once again, as the original accord proved to be a blunt instrument that did not differentiate properly among various risk types and allowed significant avenues for capital arbitrage, particularly through loan securitization. In response, authorities began crafting Basel II. However, before it could be fully implemented, the risks taken through loan securitization blew up, producing the most severe financial crisis since the Great Depression.

And as we know all too well, even if Basel II had gone into full effect, it would not have contained risk effectively nor created a sufficient buffer against losses. Thus, policy-makers have been busily constructing what may be thought of as Basel III.

Regulatory reform discussions portray the need to control systemic risk as a new game in town – as if it were a new responsibility that need only be assigned. This is not the case: Bank regulators have long viewed the containment of systemic risk as a primary rationale for capital requirements. The problem is that capital regulation has rarely been truly successful.

Requiring additional capital against risk sounds like a good idea, but it is difficult to implement. What should count as capital? How does one measure risk before an accident occurs? And how does one counteract the strong impulse of the banks being regulated to minimize required capital in highly complex ways? History has shown these issues to be quite difficult. While we do not have many examples of effective regulation of large, complex banks operating in competitive markets, we have numerous examples of regulatory failure with large, complex banks.

So, you might say I am a skeptic of regulation alone.

Resolve 'em

In my opinionated view, a traditional regulatory response – although well-intentioned – cannot, by itself, fully address the threat of TBTF. So we turn to the ‘resolve 'em’ camp. The argument goes something like this: If deeply troubled large banks are allowed to fail, the banking industry could evolve toward a market-driven structure.

During the recent crisis, regulators lamented the lack of a formal resolution process for large and complex financial organizations, claiming it reduced their options and tied their hands. So it follows that a resolution regime whereby regulators can economically resolve failed big banks might be the ticket. In this case, there will be no more TBTF.

Unfortunately, imposing creditor losses at a failing big bank while simultaneously avoiding market disruptions, involves more than a bit of sophistry. Realistically, it would be difficult to accomplish both at the same time. Based on experience, one of these goals will take precedence over the other, and history shows which goal typically wins.

The sad truth is that when the chips are down, regulators become reluctant to put their money where their mouths are – or, more precisely, they become too eager to put their money where they said they would not.

Few, if any, policy-makers have been willing to let large banking organizations fail, thereby missing an opportunity to impose significant losses on failed institutions' creditors. We know from intuition and experience that any financial institution deemed TBTF will not be allowed to fail in the traditional sense.

When such an institution becomes troubled, its creditors are protected in the name of market stability. The TBTF problem is exacerbated if the central bank and regulators view wiping out big-bank shareholders, claiming they are too disruptive, extending this measure of protection to ordinary equity holders.

In the recent crisis, authorities protected both: uninsured creditors and shareholders of big banks. While uninsured creditors received the greatest protection, regulators even partnered with existing shareholders through the injection of public funds. This program eventually spread to banks of all sizes, but its initial focus was the very largest banks. It is true that many large-bank shareholders sustained severe losses – but they were not zeroed out. They and their institutions have lived to see another day.

Why should we think the future could, realistically, be any different – especially with even bigger banks that dominate the financial landscape today? A credible big-bank resolution process that imposes creditor losses will be difficult to enforce, especially when regulators are explicitly directed to mitigate disruptions to the financial system, as they are in the proposed reform bill.

And there are still the technical problems of resolution, such as the difficulty of quickly estimating a rate of recovery on a large and complex banking organization and paying it out to creditors. Countless issues like this remain unaddressed.

For instance, how would a resolution regime market assets of a failed big bank? Major business lines presumably would be kept intact to preserve value and maximize recovery – but if one large organization were simply sold to another, the industry could become more concentrated than before. That is exactly what happened during the crisis as large failing firms were sold to other large firms.

All of this ignores a still-greater problem: Even if an effective resolution regime can be written down, chances are it might not be used. There are myriad ways for regulators to forbear. Accounting forbearance, for example, could artificially boost regulatory capital levels at troubled big banks.

Special liquidity facilities could provide funding relief. In this way, crisis-related events that might trigger the need for resolution could be avoided, making resolution a moot issue. TBTF would continue, in any case.

Shrink 'em

This leaves us with only one way to get serious about TBTF – the ‘shrink 'em’ camp. Banks that are TBTF are simply TB – ‘too big.’ We must cap their size or break them up – in one way or another, shrink them relative to the size of the industry.

In its latest version, the financial regulatory reform bill has left regulators (specifically, the [Federal Reserve] Board of Governors and the FDIC) with the authority to impose greater restrictions on firms whose living wills are not credible.

You can see why my stance on TBTF hardly endears me to audiences on Wall Street. I will Winston Churchill in response. He said, ‘In finance, everything that is agreeable is unsound, and everything that is sound is disagreeable.’ It is most disagreeable to the big bank, big money lobby to countenance restrictions on size, and hence, it is the perceived wisdom that this approach is disagreeable. And yet it is perhaps the most sound approach of all those proffered.

Some counter that even if all banks were made small or midsize (or at least not TBTF), systemic threats – and, thus, the incentive for regulators to step in and save financial institutions – would not disappear. For instance, if a lot of small banks got into trouble simultaneously, one might expect the central bank and regulators to protect bank creditors, extending TBTF protections once again.

As the argument goes, breaking up big banks may be necessary, but it is possibly not sufficient – policy-makers still must grapple with the possibility of many smaller banks getting into trouble at the same time, causing a ‘systemic’ problem.

I consider this argument hollow, for a few reasons. First, even if this possibility turned out to be true, the threat of a loss from more isolated difficulties would mean creditors could reasonably expect losses in certain circumstances – a situation unlike TBTF.

Second, going by what we see today, there is considerable diversity in strategy and performance among banks that are not TBTF. Looking at commercial banks with assets under $10 billion, over 200 failed in the past few years, and as we have seen, failures in the hundreds make the news.

Less appreciated, though, is the fact that while 200 banks failed, some 7,000 community banks did not. Banks that are not TBTF appear to have succumbed less to the herd-like mentality that brought their larger peers to their knees. We saw similar diversity during the Texas banking crisis of the late 1980s. Small banks had diverse risk exposures. The most aggressive ones failed, while the more conservative ones did not.

Some have also pointed to the Great Depression as a period when many small banks got into trouble at the same time. That situation seems less relevant to the policy questions we face today. Those failures were the result of a liquidity crisis that brought down both nonviable and viable banks. Such a liquidity crisis among small banks would be unlikely today, as we now have federal deposit insurance, which protects deposits for funding.

And, I might add, the Federal Reserve has demonstrated quite effectively over the past two years that we not only have the capacity to deal with liquidity disruptions, but also the ability to unwind emergency liquidity facilities when they are no longer needed.

The point is this: The arguments against shrinking the largest financial institutions are found wanting. And, sufficient or not, ending the existence of TBTF institutions is certainly a necessary part of any regulatory reform effort that could succeed in creating a stable financial system. It is the most sound response of all.

The dangers posed by institutions deemed TBTF far exceed any purported benefits. Their existence creates incentives that will eventually undermine financial stability. If we are to neutralize the problem, we must force these institutions to reduce their size.

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas. This article is adapted from a speech delivered at the Southwest Graduate School of Banking's 53rd Annual Keynote Address and Banquet in Dallas.


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