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End 'Too Big to Fail' by Making It Shareholders' Problem

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Despite the best efforts of a divided Congress, the world knows that the malignancy of too-big-to-fail endures to this day. An ever growing roster of public officials, industry participants and academics has voiced its opprobrium of TBTF banks as equal-opportunity abusers.

TBTFs abuse taxpayers with their stealth subsidy. They abuse their customers and competitors with skewed pricing. And, worst of all, they abuse the financial system by exposing it to yet another series of bailouts.

It seems that departing Treasury Secretary Timothy Geithner, former Rep. Barney Frank, and the leaders of the TBTFs themselves, are the remaining holdouts endorsing the notion that, in finance, bigger and more complex is better.  We are fortunate, however, that broad and bipartisan support has emerged to address this persistent problem.  Evidence of this can be found in the demand of a unanimous Senate, spurred to action by Sens. Sherrod Brown and David Vitter (politically, as odd a couple as can be imagined), that the Government Accountability Office measure the taxpayer subsidy afforded the TBTFs.

Last week, former FDIC chairman William Isaac and I laid out a new approach for solving the TBTF problem. While fair, transparent and simple, it relies on market discipline, not heavy-handed government intervention for its execution. It will result in smaller, more vibrant, and more competitive firms – firms that contribute to the economy rather than abuse it. It's called the Subsidy Reserve Plan.

In sum, the plan would require each TBTF to establish a "subsidy reserve" line item on its balance sheet and add to it each year the estimated subsidy it receives from taxpayers in the form of reduced funding costs. The estimate would come from the GAO study supplemented by work of the new Office of Financial Research.

The reserve would not substitute for the bank's regulatory capital but would be available to protect creditors and the Federal Deposit Insurance Corp. in the event of failure.

The reserve would accrue year after year and could be distributed to shareholders only in proportion to a bank's shrinkage via asset sales, divestitures or spin-offs. A proportionate share of the reserve would be allocated to such sales and divestitures. It could not be used for dividends, share buybacks or bonuses. If the bank shrank to a size such that it was no longer perceived as too big to fail, the subsidy reserve requirement would end and the remaining balance in the subsidy reserve account would be combined with unrestricted capital .

Absent such sales and divestitures, the reserve would accumulate over time such that it would be shareholders – not regulators or politicians – that would demand the shrinking of the bank. This is market discipline in its purest form.

Here is the actual legislative language to implement the Plan—all 293 words of it:

SECTION 1.  Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act is amended by adding after subsection k:

 "(l)  The Subsidy Reserve

 (1) The Board of Governors shall require each nonbank financial company supervised by the Board of Governors and each bank holding company with total consolidated assets equal to or greater than $500,000,000,000 to establish and maintain a capital account called the "Subsidy Reserve.

(2) In consultation with the Financial Stability Oversight Council and the Office of Financial Research, the Board of Governors shall, after notice and opportunity for hearing, establish a formula for determining the financial benefit received by such firms as a result of the expectations on the part of shareholders, creditors, and counterparties of such firms that the Government will shield them from losses in the event of failure.

(3) The Board of Governors shall require each firm described in subsection (1) to apply the formula of subsection (2) to its financial statements annually and to maintain a minimum amount of capital in its Subsidy Reserve equal to the cumulative results of that formula.

(4) The Subsidy Reserve shall not be used to satisfy any other capital requirements.

(5) Other than as described in subsection (6) the Subsidy Reserve shall not be diminished through dividends, share buybacks, or otherwise distributed to shareholders or diminished through payments to insiders of the firm.

(6) The Subsidy Reserve may be diminished in connection with a firm's sale of assets, the spinoff of subsidiaries, or other such divestiture in which case a proportion of the Subsidy Reserve will be allocated to the divested property on either a pro rata basis or according to the risk weighting of the divested property as determined by the Board of Governors either by order or regulation.

(7) The Board of Governors may issue such regulations and orders as it considers necessary to implement this subsection.

I know it's unusual to include the text of a bill in an op-ed such as this. But what the above demonstrates is that it does not take 2,300 pages of law to achieve meaningful reform.

My most fervent hope is that the new Congress and the new Secretary of Treasury agree.

Cornelius Hurley is director of the Boston University Center for Finance, Law & Policy and former assistant general counsel at the Board of Governors of the Federal Reserve System.

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Comments (8)
Reenactment of Glass-Steagall, now in the Congress as H.R. 129, is a simpler, better solution that requires no regulation, no set-asides, works immediately, and is transparent to the public as well as bankers. It was successful until eviscerated and ultimately repealed in 1999. FDIC Vice Chair Thomas Hoenig endorsed it Jan. 16 for these reasons, as did Dallas Fed head Richard Fisher in all but name by calling for no federal bankstop for anything but commercial bank activities Jan. 17. Go back to it immediately to stop a hyperiflationary explosion by the Fed.
Posted by anitagallagher | Wednesday, January 23 2013 at 1:35PM ET
This is the most convoluted way to accomplish a simple task that I have seen yet on these pages. If the goal is to replace hyper-regulation with market discipline, then the method is simple: End deposit insurance. Announce the closing of the FDIC after a three-year "sunset" window.

Without the subsidy of deposit insurance, banks will restructure themselves into healthier, less risky economic entities. Safety and soundness will become a basis of competition, as will risk/reward. Shareholders and executives will bear their fair share of the risk. Some banks will remain very large specialists in transactional banking. Others will become specialized lending companies with deep expertise in their fields. Still others will become investment managers with a range of debt, equity and other funds. We will end up with a much stronger system that does a better job of satisfying its customers. Markets not subject to the distortion of politicized, government mandates are always more efficient.
Posted by Bob Newton | Wednesday, January 23 2013 at 1:47PM ET
Thought provoking article Professor Hurley. For there to be market discipline, however, banks have to have in depth on- and off-balance sheet risk disclosures, so that market participants, i.e. investors, ratings agencies, and retail individuals can discipline banks by walking away when they see transactions that are too risky or banks that are badly mismanaged. This would cause yields to widen and stock prices to fall; these market signals would be useful not only to investors but to regulators as well. Basel III's Pillar III has good guidelines for such disclosures, however, in the US this Pillar has not been adopted. In Europe, whilst being adopted it is not uniformly implemented, making the disclosures not terribly useful. Hence, market discipline remains an elusive ideal. Mayra Rodriguez Valladares, MRV Associates
Posted by MRVAssociates | Wednesday, January 23 2013 at 3:29PM ET
I agree with Dr Hurley's decision to include Section 165 of Dobb-Frank in his op-ed, for it lends credibility to his argument. But I respectfully disagree that the bail-outs of the banks was such a terrible thing. Unlike the GM bail-out the US tax-payers actually made money on the banks through interest and warrants in the tens of billions of dollars (I do not know the actual number).
Posted by Chip52 | Wednesday, January 23 2013 at 4:54PM ET
Banks would never be shareholders' problem. They have been and will be depositors' problems. Bank shareholders and CEOs have been the largest beneficiaries of high leverage permitted by bank regulators all over the world.You may just review Deposit to Equity,Return on Funds Employed and Return on Equity ratios of banks anywhere.Even minimum capital adequacy ratio of 8% of Basel permits 12 times leverage of risk capital. Must take care of depositors in any scheme of things.Banks are thus different from other businesses.
Posted by Center for Safe and Sound Banking | Wednesday, January 23 2013 at 5:23PM ET
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