Former Federal Reserve chairman Ben Bernanke had a striking assessment of the dangers faced by the U.S. economy in 2008, according to a recently disclosed document filed as part of the ongoing litigation related to the government bailout of American International Group. Bernanke reportedly said that 12 of the 13 largest U.S. financial institutions were on the verge of failure in autumn of 2008. Thus the Fed needed to take extraordinary rescue measures to save AIG and other banks to avoid financial catastrophe. Bernanke’s comment provides a vivid reminder of the danger posed by too-big-to-fail institutions.
The 2010 Dodd-Frank Act, which included the orderly liquidation living wills requirement, was meant to prevent future rescues of systemically important financial institutions. But the idea that current regulations are capable of solving the too-big-to-fail problem was challenged by the recent regulatory rejection of 11 banks' living wills. Some argue that living wills are a work-in-progress that will improve over time. However, the truth is that living wills are a myth meant to calm the populace. It is impossible to neatly unwind a failed SIFI, since the failure of such a large institution will necessarily cause unacceptable collateral damage.
There are several options for dealing with too big to fail. Unfortunately, some of the most promising options are also among the most unlikely.
SIFI banks might voluntarily reengineer themselves to become small enough to fail again. The SIFI experiment is relatively recent, having begun in the mid-1990s in the midst of deregulation and large bank consolidation. Since the experiment went bust within 10 years of its start, with all of the country’s largest banks requiring government bailouts, one might question the usefulness of preserving such a toxic model. But big banks continue to be implicitly supported by the government, and they have little incentive to give up the benefits that their size accrues to them.
An alternative would be to make big banks too safe to fail by substantially increasing their equity capital levels, along the lines of the proposal outlined by Anat Admati and Martin Hellwig in The Bankers' New Clothes. Raising capital requirements would reduce the benefits of being big. Unsurprisingly, banks are fighting this proposal.
My preferred approach would be to reduce the size of SIFIs so that they are small enough to fail. This could be achieved through ring-fencing various business lines and spinning off others. This action reduces the size of a bank’s vulnerability rather than simply responding to the crisis. Whatever alleged loss of efficiency banks incurred would be offset by increased financial stability. Unfortunately, an equally stiff resistance to this idea can be expected.
Another possibility would be for legislators and regulators to recognize that big banks are de facto government-sponsored entities like Fannie Mae and Freddie Mac, and should managed as such. Hopefully, they would be managed with better results this time. While this may be wishful thinking, such an approach would at least recognize the issue of SIFIs as a political problem that requires a political solution.
The most likely course of action is that regulators will maintain the status quo and change nothing of substance, relying on cosmetic fixes to give voters a false sense of security. Some free market enthusiasts might argue that the status quo isn't so bad, so long as customers and not regulators decide how big banks should be. But the SIFI market is anything but free. The big bank model failed in late 2008; in a free market, these banks would have ceased to exist. They survived because they are the creations of the government, not the free market. Exempt from market discipline, they represent crony capitalism at its worst.
Unless something changes, big banks will continue to blow up, and taxpayers will continue to rescue them. It's all too easy to imagine facing another October 2008. At least we have Bernanke to thank for reminding us of this risk.
J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.