The Danger Posed By The Too-Big-To-Fails

The Danger Posed By The Too-Big-To-Fails WORD ON THE STREET: Just as health authorities in the U.S. are waging a campaign against the plague of obesity, banking regulators must do the same with regard to oversized banks that undermine the nation's financial health and are a potential threat to economic stability.

Aspiring politicians do not have to be part of the Occupy Wall Street movement or be advocates for the Tea Party to recognize that government-assisted bailouts of reckless financial institutions are sociologically and politically offensive; they stand the concept of American social justice on its head.

Business school students will understand that bailouts of errant banks are questionable from the standpoint of the efficient workings of capitalism, for they run the risk of institutionalizing a practice that distorts the discipline of the marketplace and interferes with the transmission of monetary policy.

I argue that sustaining too-big-to-fail-ism and maintaining the cocoon of protection of the ‘systemically important financial institutions’ (SIFIs) is counterproductive, expensive and socially questionable. Financial booms and busts are a recurring theme throughout history, and bankers and their regulators suffer from recurring amnesia. They periodically forget the past and all the lessons of history, tuck into some new financial, quick-profit fantasy – like the slicing and dicing and packaging of mortgage financing – and underestimate the risk of growing into unmanageable and unsustainable size, scale and complexity as they overindulge in that new financial fantasy.

Invariably, these behemoth institutions use their size, scale and complexity to cow politicians and regulators into believing the world will be placed in peril should they attempt to discipline them. They argue that disciplining them will be a trip wire for financial contagion, market disruption and economic disorder. Yet failing to discipline them only delays the inevitable – a bursting of a bubble and a financial panic that places the economy in peril. This phenomenon most recently manifested itself in the Panic of 2008 and 2009.

Paul Volcker states the problem thus: ‘The greatest structural challenge facing the financial system is how to deal with the widespread impression – many would say conviction – that important institutions are deemed 'too large or too interconnected' to fail.’

Perpetuating obesity

With each passing year, the banking industry has become more concentrated. Half of the entire banking industry's assets are now on the books of five institutions. Their combined assets presently equate to roughly 58% of the nation's gross domestic product (GDP). The combined assets of the 10 largest depository institutions equate to 65% of the banking industry's assets and 75% of the nation's GDP.

Some of this ongoing consolidation is the result of a dynamic set in place by Congress' passage of interstate branching legislation in 1994 and repeal of Glass-Steagall provisions in 1999. But some of it also reflects the result of the recent financial crisis.

When difficulties began to appear at large financial institutions, resolution policies often entailed their merger or acquisition with other large institutions. Add to this the regulatory forbearance and financial backstops that tend to be granted to the largest banks in exigent circumstances, and the end result is a few financial behemoths, each with well over a trillion dollars in assets and a heavy concentration of power.

In fact, the top three U.S. bank holding companies each presently have assets of roughly $2 trillion or more. Of course, problems in the banking sector have not been exclusively confined to large financial institutions. Regional and community banks have faced their own problems, especially connected to construction lending.

But here is the rub: When smaller banks get in trouble, regulators step in and resolve them. The term ‘resolve’ in the context of smaller banks is a fancy way of saying their demise was quickly and nondisruptively arranged – they were disposed of.

We might have expected equal treatment of big banks, but, of course, that did not happen. To be sure, some very large financial firms have ceased to exist or have been through a corporate reorganization with some of the characteristics of a Chapter 11 bankruptcy. But these institutions deemed ‘too big to fail,’ and considered to be ‘systemically’ important due to their size and complexity, were given preferential treatment. Many were absorbed by still larger financial institutions, thus perpetuating and exacerbating the phenomenon of too-big-to-fail.

This problem of supersized and hypercomplex banks is not unique to the U.S. Europe is struggling today with how to cushion its megabanks from excessive exposure to intra-European sovereign debt. And Japan is still feeling the negative impacts of not successfully resolving the financial difficulties at its megabanks two decades ago.

A perverse Lake Wobegon

In today's interconnected, globalized financial system, systemic risk is more pronounced than ever. And we know that when a systemic crisis occurs – as it did in the Panic of 2008-2009 – the results can be catastrophic to the economy. Small wonder that in commenting on the problems currently besetting Europe, the U.S. Treasury secretary recently stated, ‘The threat of cascading default, bank runs and catastrophic risk must be taken off the table.’

This has become dogma among banking regulators and their minders. Thus, in the recently announced Greek bond deal, the Euro Summit Statement tells us that ‘Greece requires an exceptional and unique solution.’

Such a solution is certainly in the interest of American bankers. The New York Times reported that the Congressional Research Service (CRS) has estimated that the exposure of U.S. banks to Portugal, Italy, Ireland, Greece and Spain amounted to $641 billion; U.S. banks' exposure to German and French banks was in excess of an additional $1.2 trillion. According to the Bank for International Settlements, U.S. banks have $757 billion in derivative contracts and $650 billion in credit commitments from European banks.

Thus, the CRS concluded that ‘a collapse of a major European bank could produce similar problems in U.S. institutions.’ In the land of the too-big-to-fails, we find ourselves in something akin to a perverse financial Lake Wobegon: All crises are ‘exceptional,’ and all require ‘unique solution(s).’

Yet, it seems to me that in our desire to avoid ‘cascading default’ and ‘catastrophic risk,’ and in our search for "exceptional and unique solution(s),’ we may well be compounding systemic risk, rather than solving it. By seeking to postpone the comeuppance of investors, lenders and bank managers who made imprudent decisions, we incur the wrath of ordinary citizens and smaller entities that resent this favorable treatment, and we plant the seeds of social unrest. We also impede the ability of the market to clear or, to paraphrase John Milton, allow the marketplace to distinguish ‘freely’ those who should stand and those who should fall.

Enter Dodd-Frank

In response to the Panic of 2008-2009, we are implementing the Dodd-Frank Act – which is over 2,000 pages long, and contains 16 titles, 38 subtitles and a total of 541 sections. It is the most complex document ever written in the history of efforts to change the financial regulatory landscape.

A cheeky historian might recall French Prime Minister Georges Clemenceau's reaction to Woodrow Wilson's 14 points, proposed as a safeguard for world peace after World War I: Clemenceau is reported to have thought that God did a pretty good job with only 10.

Whether it is through 10 commandments or 14 points, or over 2,000 pages, the question is: Does Dodd-Frank appropriately confront systemic risk and the associated problem of too-big-to-fail? Its preamble certainly states a desire to do so, declaring boldly that its purpose is to ‘end 'too big to fail'’ and ‘protect the American taxpayer by ending bailouts.’

Dodd-Frank does, in fact, contain a number of measures that attempt to address too-big-to-fail-ism. It creates a Financial Stability Oversight Council (FSOC) composed of the major financial-sector regulators charged with overseeing the entire financial system. The FSOC can recommend that important non-bank firms be brought under the regulatory umbrella. Those who will be brought under that umbrella will be subjected to periodic stress tests to make sure they can withstand reversals in the economy and other adverse developments.

Dodd-Frank also calls for enhanced capital requirements for SIFIs, and it provides for a new authority for resolving bank holding companies and other financial institutions.

Will it work? The devil, as always, is in the details of how the legislation is implemented.

At the most basic level, the legislation leaves many of the details to rulemakings by various regulatory agencies; more than one year after enactment, there is still much work to be done in actually implementing the act.

On Nov. 1, 2011, the law firm Davis Polk & Wardwell released its monthly progress report on Dodd-Frank implementation. According to that report, of the 400 rulings required by the legislation, 173, or roughly 43%, have not yet been proposed by regulators. Of the 141 rulemakings required of bank regulators – the Federal Reserve, Federal Deposit Insurance Corp. (FDIC) and Office of the Comptroller of the Currency – 58, or about 41%, have not yet been proposed.

An Achilles' heel

For all that it specifies to treat the unhealthy obesity and complexity of too-big-to-fails, Dodd-Frank has an Achilles' heel. It states 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.’ This is entirely desirable; nobody wants to initiate serious financial disruption.

But directing the FDIC to mitigate the potential for serious adverse effects leaves plenty of wiggle room for fears of ‘cascading defaults’ and ‘catastrophic risk’ to perpetuate ‘exceptional and unique’ treatments, should push again come to shove.

I may be excessively skeptical on this front. Vigilantes of the bond and stock market, of which I was once a part, have been demanding greater transparency in reporting the exposures of the megabanks, including a more fulsome account of both gross and net exposures of credit default swaps. And Moody's has recently downgraded the long-term debt of major U.S. and U.K. banks.

This is oddly reassuring. Moody's said that ‘actions already taken by U.K. authorities have significantly reduced the predictability of support over the medium to long term,’ whereas in the U.S., it found ‘a decrease in the probability that the U.S. government would support [major banks].’

Of course, the ratings agencies did not exactly cover themselves in glory during the crisis. Let's hope their assessment of at least somewhat more limited government support for the megabanks proves more accurate than the AAA ratings they gave to so many mortgage-backed securities.

The alternative: radical surgery

In short, progress is being made in the direction of treating the pathology of SIFIs and the detailing of enhanced prudential standards governing their behavior. Yet, in my view, there is only one fail-safe way to deal with too-big-to-fail. I believe that too-big-to-fail banks are too-dangerous-to-permit. As Mervyn King, head of the Bank of England, once said, ‘If some banks are thought to be too big to fail, then â�¦ they are too big.’

I favor an international accord that would break up these institutions into a more manageable size – more manageable not only for regulators, but also for the executives of these institutions. For there is scant chance that managers of $1 trillion or $2 trillion banking enterprises can possibly ‘know their customer,’ follow time-honored principles of banking and fashion reliable risk management models for organizations as complex as these megabanks have become.

Am I too radical? I think not. I find myself in good company – Paul Volcker, for example, advocates ‘reducing their size, curtailing their interconnectedness or limiting their activities.’

In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Then, creative destruction can work its wonders in the financial sector, just as it does elsewhere in our economy.

We shouldn't just pay lip service to letting the discipline of the market work. Ideally, we should rely on market forces to work not only in good times, but also in times of difficulties. Ultimately, we should move to end too-big -to-fail and the apparatus of bailouts and do so well before bankers lose their memory of the recent crisis and embark on another round of excessive risk taking. Only then will we have a financial system fit and proper for servicing an economy as dynamic as that of the U.S.

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas. This article is adapted and edited from a recent speech delivered before Columbia University's Politics and Business Club in New York. The full text is available online.

(Photo courtesy of the National Gallery, Oslo)


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