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

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.


(8) Comments



Comments (8)
I am the George Hartzman Rolling Stone's Matt Taibbi wrote of the other week, and I believe Wachovia CEO Robert Steel bought Wachovia's stock in a breach of trust, confidence and his fiduciary duty to shareholders, US taxpayers and our legal system, while in possession of material, nonpublic information.

On July 9, 2008, Robert Steel became president and CEO of Wachovia after working for Goldman Sachs from 1976 to 2004 and the US Treasury under former Goldman Sachs CEO Henry Paulson from October 10, 2006 until July 9, 2008. Mr. Steel was "the principal adviser to the secretary on matters of domestic finance and led the department's activities regarding the U.S. financial system, fiscal policy and operations, governmental assets and liabilities, and related economic matters," according to Wikipedia's biography. Mr. Steel most likely knew about other firm's borrowings via his time spent at the U.S. Treasury Department.

On July 22, 2008, Mr. Steel personally purchased 1,000,000 shares of Wachovia's stock as the company's undisclosed Federal Reserve Term Auction Facility (TAF) borrowing reached $12.5 billion, which appears not to have been disclosed in securities filings audited by KPMG.

In an interview with CNBC's Jim Cramer On Monday, September 15, 2008, Robert Steel said "I think it's really about...transparency. People have to understand the assets and really be able to say, this is what I own... Complete disclosure. ...we can work through this with transparency, liquidity and capital. ...Our strategy was to give you all the data so you could make your own model. We tell you what we're doing... ...we're raising capital ourselves by basically shrinking the balance sheet, cutting the dividend, cutting expenses. We can create more capital ourselves that way... for now, we feel like we can work through this..." After Jim Cramer asked "Should there be any sort of quick regulatory relief from the SEC that would make life easier to be able to make your bank much stronger?", Mr. Steel responded "I don't think it's about my bank."

After not reporting TAF loans, Wachovia's CEO wrote "I, Robert K. Steel, certify that: I have reviewed this Quarterly Report on Form 10-Q for the quarter ended September 30, 2008 of Wachovia Corporation; Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report" on October 30, 2008.

Mr. Steel was at least aware of Wachovia's Federal Reserve loans since July, 2012, if not the undisclosed loans to multiples of other financial institutions.

If Mr. Steel was "the principal adviser...on matters of domestic finance and led the department's activities regarding the U.S. financial system, fiscal policy and operations", how could he not have known and acted on undisclosed material information?

On June 22, 2010, Robert Steel was appointed Deputy Mayor for Economic Development by New York City Mayor Michael Bloomberg, after which, Steel resigned his seat on the Wells Fargo board. According to Morningstar data, Mr. Steel owned 601,903 shares of Wells Fargo in 2010, which would be worth $20,446,644.91 as of October 26, 2012.

George Hartzman
Greensboro, North Carolina
Posted by Hartzman | Sunday, January 27 2013 at 9:30PM ET
Characterizing large banks as malignant and equal opportunity abusers hardly counts as objective or rational. A fair examination would begin with the question why do the large banks exist? Does the market want them? Do they provide services that smaller banks cannot? Would breaking up the large banks in the US result in a shift of the world's financial centers to other nations? The best way to ensure that banks are safe and sound is to be sure they are viable businesses, that there is sufficient demand to sustain the business then regulate that business. If the market wants big banks then we should let them happen. TBTF is not a bank issue. Banks are not the only corporations too big to fail. GM and Chrysler got bailed out too. The reason for the bailouts was to minimize the risk and harm to the nation, to the people employed by these companies, to the people who rely on those employees, on the other businesses that rely on those companies. The cost to the nation was far less by bailing them out than if they had failed. It is a no brainer. So should be break up every business that is too big to fail? Could Chevrolet or maybe just one part of Chevrolet compete successfully by itself against VW and Toyota? When is scale an important competitive factor? Because of certain tax issues I suspect that Cadillac by itself could not compete with Mercedes and Lexus. I also suspect that community banks could not provide the services needed by large international companies. Mr. Hurley's implicit presumption that TBTF is fundamentally and irredeemably malignant and malevolent and must be eliminated lacks credibility unless he can show that the evil outweighs the good and the market doesn't need these companies.
Posted by gsutton | Wednesday, January 23 2013 at 8:02PM ET
I don't know who CSSB is, but the mere statistics they cite in a vacuum seem disconnected from their rather vague point. What does it mean to "take care of depositors in any scheme of things"? How do they propose to do it? Are they not being taken care of now? Whom do they want to be responsible for "taking care of depositors" and why?

Since, in the US and most developed countries, virtually all individual depositors are covered by government guarantees, why does CSSB say that banks are presently the depositors' problem?

Is it not possible that the industry's high leverage is due to the fact that deposits are insured, and that without such insurance the market would demand either lower leverage or less risky portfolios, and more transparent disclosure than the government regulators require today?

As to whether banks can never be shareholders' problem, I wonder if the former shareholders of Lehman Brothers or Bear Stearns would agree.
Posted by Bob Newton | Wednesday, January 23 2013 at 6:02PM 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
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
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
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
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
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