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The Brilliant Solution to TBTF No One Is Talking About

The debate over "too big to fail" banks is about to reignite, courtesy of the Federal Reserve Bank of New York.

On Tuesday, the New York Fed released an insightful series on how U.S. global systemically important banks received a funding advantage before Dodd-Frank and Basel III started being implemented. Moreover, one of its studies found big banks engage in riskier transactions, because they believe the government will not let them fail.

At the same time, however, the researchers found that breaking up the big banks, would hurt the economy. Unfortunately, taxpayers who have been forced to share the downsides without the upsides remain significantly exposed to the enormous credit, market and operational risks posed by TBTF banks.

For over a year, I have been analyzing bills that aim to end TBTF. In the current political environment, any bill that advocates breaking up big banks or taxing them has little chance of ever seeing the light of day. However, there is an excellent bill, H.R. 2266, that would go a long way in protecting taxpayers sitting in the office of Michael Capuano, D-Mass. It deserves to be heard by the House Committee on Financial Services.

H.R. 2266, the Subsidy Reserve Plan, would require banks over $500 billion in assets to identify on their balance sheets the portion of retained earnings that is attributable to the subsidy they receive for being TBTF. This Subsidy Reserve would count as capital for insolvency purposes but not for Basel III purposes. The reserve could not be used to pay dividends or for share buybacks. It could be monetized only in connection with the disposition of assets.

Not only would this bill make banks healthier and protect taxpayers, it would not require either political party to sacrifice its ideology. If the bill is that good, what am I missing? I took it upon myself to spend the last couple of weeks in search of different experts to talk to me about the bill.

Prof. Cornelius Hurley, Director of the Boston University Center for Finance, Law & Policy is the mastermind behind the bill. According to Hurley, the "accumulation of this reserve would incentivize TBTF banks to deleverage and to right-size themselves." This additional capital requirement could be the equivalent of Basel III's capital charge for systemically important financial institutions, but as Professor Hurley explained, ‘it would not have a cap."

Representative Capuano told me, "The idea behind my legislation is simple. If banks get a subsidy, we should quantify it and banks should hold capital sufficient to cover it. If they don’t get a subsidy, the legislation won’t have any impact on them. The process of determining the scope of the subsidy would be transparent and the Federal Reserve would write the formula. If a bank’s shareholders decide that it’s not worth holding capital in reserve to pay for the subsidy, they would be free to downsize their institution."

Notable academics support of H.R. 2266. Prof. Edward Kane of Boston College called a "very good step to measure of taxpayer stake. Taxpayers are hapless. There is no criminal punishment against banks, so they continue to take risks." The bill would also help regulators, because as Kane explained, "regulators are always outgunned by banks and playing from behind." Prof. Harvey Rosenblum, of SMU Cox and formerly at the Dallas Federal Reserve, says banks' incentives need to change. "We cannot rely on government regulators to do everything. We need to work on incentives," he emphasized. "It is a shame that H.R. 2266 cannot get a sponsor; it goes in the right direction." Rep. Capuano stated today that he is "in the process of educating my colleagues about this approach, including working to secure a Republican co-sponsor."

Rosenblum correctly pointed out that "if we look at capital ratios of community banks and those of the gargantuan ones, community banks have better ratios. There is something wrong with this picture. The exposure to the taxpayer not been legislated; this is unconstitutional." I asked him why, if H.R 2266 is a good step in the right direction, it is not moving forward? "We are embarrassed of not thinking of this first," Rosenblum said. "Even I would put myself in this camp."

Duke Law School Professor Lawrence Baxter believes it might take "another crisis before politicians move on a bill like H.R. 2266." Another milestone in the TBTF debate will be when the GAO releases part II of a study to quantify the subsidy that TBTF banks get; the first study released in November 2013 "raised questions about the appropriate scope of government safety nets for financial institutions." When the GAO releases the new study, probably in July, "banks will deny that they get a subsidy," said Baxter. "H.R. 2266 might open up a Pandora’s box about the role of government to provide subsidies to any sector of the economy."

I contacted a number of bank professional associations as well as Republicans. Either they did not respond or those that did said that they were "too busy to talk about H.R. 2266." A staffer for a leading Democrat confided that since H.R. 2266 is a moderate, nonpartisan bill, it does not motivate anyone to co-sponsor it. "It does not help us get votes."

Is this really what Washington has come to? Re-election rather than protecting taxpayers is the main priority. Certainly taxpayers deserve better.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World.


(13) Comments



Comments (13)
This TBTF issue have gone so far. It is so hard to prove that the US average taxpayer that banks are also known as "too big to fail" are entitled to their trust. As Bankrate reported that signs are very simple to see. Bankers surveyed in the same poll seemed oblivious to the truth, as they trusted that consumers trust them. Not even some personal loans will help consumers trust banks more.
Posted by Spicyme | Thursday, April 10 2014 at 7:03AM ET
Mr. Dillon's premise is incorrect: neither banks nor any large businesses have a "debt to society"; by the same token, there is no need for "society" to "insure their on-going size and success". Therefore his conclusion about regulation being "debt collection" is logically false.

There is a historic basis for invading other countries and subjecting their people to slavery, but that does not constitute a moral basis. It's the same with bank regulation.

Let the customers decide. Suppose you are a depositor, choosing between two banks, under the only regulation that financial reporting be honest and transparent. One is publicly-traded and you know that its board members have broadly diversified wealth. The other is private and you know that all of its executives, down to the VP level, are required to hold 90% of their personal net worth in preferred and common stock of the bank. Which would you choose? Do you think people in general are too stupid to make a similar choice? If so, you are probably a fan of government regulation.
Posted by Bob Newton | Wednesday, April 02 2014 at 12:03PM ET
Don't Break Up Megabanks, Re-Engineer Them

Bank Think | Aug 1, 2012
Shouldn't we want to preserve the benefits of being big, global and diversified if society can manage these banks' risk exposures and support their stabilizing effects on economic order?
Posted by Allan Grody | Wednesday, April 02 2014 at 10:51AM ET
The financial, political and social advantages of "big" have always existed in one form another. After all, "growth" is a constant given in the measure of success and well-being, especially in the for-profit world of business. So, if we are suddenly concerned that these advantages are "unfair" for the smaller players simply because the advantages have been attributed to and branded "Too Big To Fail", then we are going to have (big) bankers, (big) politicians and (big or wanna be big) people generally ignoring such silly and patently untrue argument. It is not unfair to want to become big and important in any society, and even less so to succeed.

But, if the complaint against TBTF is that they have a debt to the society that has provided them the "environment to succeed", that the debt can and should be monetized, and that it is an outstanding debt that needs to be collected for the benefit of the society that maintains the environment that provides for and insures their on-going size and success, then the proposition of HR2266 is not a matter of fairness or size, but simply one of collecting on a debt. And Big Bankers, Big Politicians and Big People everywhere would unanimously agree: Debt Collection is a worthy cause; and Past Due makes it that much more immediate.
Posted by mdillon | Saturday, March 29 2014 at 10:31AM ET
I have seen the bank regulatory system from the inside, as a former regulator, so I know what the facts are. "Progressives" can strike whatever poses they wish, but the essential fact remains the same: government "dirigisme" never produces a better outcome than free people achieve, and violates everyone's rights while depressing the economy. Of course they fear the free market, since it would eliminate their source of personal power and political-class superiority over us mere citizens.

Recessions are an economic cycle, as inevitable as the weather. Nothing in bank regulation has done anything to reduce them; in fact, government interference has created, deepened and prolonged economic downturns from the 1930s to 2008. The best example of a recovery from recession is the 1921 recession, in which the government expressly did nothing. It was the shortest recession, and one of the fastest returns to growth, in American history.
Posted by Bob Newton | Saturday, March 29 2014 at 6:27AM ET
Bob, there is a real historic basis for regulating banks and markets. Recession-inducing bank panics and bond market crashes were regular features of the U.S. economy from independence until the 1930s. Things were relatively stable since the Depression until 2008. As teknoscribe suggests, banks don't pay for the collateral damage when they fail. "Free market" banking winds up being very expensive for the rest of us.
Posted by stochastics | Saturday, March 29 2014 at 4:08AM ET
Oh Bob, Bob, Bob. It may be far too late to make the financial ship seaworthy, as you suggest. If the banks were, in practice, willing to carry the risks to their termination (and, er, fail) or accept the legal consequences of their behavior, the argument might hold water.

Past evidence suggests they aren't interested in taking risks at their own expense. Taking them at the American public's expense, however, is another story.

The use of the "thought terminating cliche" (progressive = fascist) is a nice rhetorical flourish, but still a fallacy. Perhaps you can explain what deposit insurance has to do with the over-leveraged ponzi schemes (er, that is, CDOs, CLOs and other new age, fun vehicles) that we can all hear ticking over there in the corner? My kids can't wait to pay for that party.
Posted by teknoscribe | Friday, March 28 2014 at 10:04PM ET
This article is one of the better ideas for re-arranging the Titanic deck chairs. But as soon as somebody talks about the government "incentivizing" or otherwise manipulating people and businesses who, constitutionally, should be free to take their own business risks at their own expense, I know I'm dealing with a "Progressive" - i.e., fascist-lite - who thinks that government masterminds know better than the market.

The solution to all of this is very simple: end government-provided deposit insurance. Banks will find their own ways to restructure to offer the best combination of safety, risk and reward to their customers. Perhaps that will include private deposit insurance, perhaps not. But we will not find the best solution until banks and their customers are free to make their own decisions.
Posted by Bob Newton | Friday, March 28 2014 at 6:36PM ET
Re-election is by far the highest priority for most legislators. That's why so many ideas that are either most useful (but not necessarily popular) or most radical come from lawmakers in safe districts. Not really a surprise here.
Posted by stochastics | Friday, March 28 2014 at 5:53PM ET
This proposal is unworkably complicated. It makes far more sense to increase SLOWLY the leverage ratios allowed banks as they become bigger. That makes each incremental decision more important. If it requires ahigher capital ratio to be 900 billion than 800 billion, the bank will choose its business more profitably and carefully. That is the only logical solution. That also creates a more level playing field for smaller institutions not enjoying the implied guarantees. The most profitable institutions will raise capital and grow, the less profitable will see their return on equity fall and either charge more to raise their returns or cut down to the most profiable business.
Posted by pdf70101862 | Friday, March 28 2014 at 4:23PM ET
It seems to me that the argument is based on a weak premise.

Riskier loans are not necessarily defined by ratio of impaired loans to total assets; and particularly not during the tumultuous period of 2007 - 2013.

Further, I am sure that some may find it shocking that larger Banks enjoy a funding advantage, but doesn't this simply come down to risk-based pricing. All else equal, a larger company is less risky than a smaller one. Google is less risky than a Silicon Valley start-up. a $500 billion asset size bank is less risky than a $100 million asset size bank.
Posted by Serge Milman | Thursday, March 27 2014 at 11:16PM ET
Excellent work. Like the proposed bill, analysis like this deserves better exposure. If anyone still thinks mortgages serve any interest other than those of the lenders, they are pretty delusional. Requiring banks to limit their risk in the fashion proposed in H.R. 2266 could serve as the first baby step toward social responsibility and ethical business conduct.
Posted by teknoscribe | Thursday, March 27 2014 at 11:01PM ET
Rightsizing in this economy means more unemployment, does it not? We are hurting the Banks enough already. We need to be incentizing them to make mortgages., The housing industry needs to be much healthier if we are going to have a good economy. Our unemployment rate is a joke. We are hurting badly. This is not the time to create more hurt on people!
Posted by robrose | Thursday, March 27 2014 at 7:19PM ET
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