The Little Bill that Could Take Down TBTF

A House bill clocking in at a mere 341 words could accomplish what the unwieldy Dodd-Frank Act has failed to do: use market discipline to rightsize "too big to fail" banks. The legislation takes direct aim at the "financial benefits" of being "too big to fail."

The Subsidy Reserve Act now before Congress is not only compact, it is also simple, fair and designed to be easily implemented. After a thorough and public vetting process led by the Federal Reserve Board, it would bring into the open the financial benefits of being TBTF — benefits the big banks claim to be nonexistent.

HR 888 would require the truly TBTF banks (those very few with assets over $500 billion) to quantify the "financial benefits" they receive from anticipated taxpayer support. The TBTFs would simply be required to identify that part of their retained earnings each year that is attributable to this added financial benefit or, as many refer to it, their "subsidy."

The subsidy reserve will accumulate indefinitely year over year. It may be returned to shareholders only in connection with the rightsizing of the TBTF firm, i.e., in connection with a divestiture, sale of assets, spin-off or other market-driven M&A event. As banks become overcapitalized, market discipline in the form of shareholders’ pressure to more efficiently deploy their capital will drive the bus, not the Fed.

But big banks are pushing back against the bill because they value complexity and opacity over simplicity. Complexity and opacity are the handmaidens of the implicit federal guarantee that forms the foundation of each TBTF bank.

It is, after all, to preserve opacity that the big banks seek to keep obscure financial instruments trading in the OTC market rather than on transparent exchanges. As long as trading remains in the shadows where information is proprietary, banks can set their own prices and make big scores at the expense of customers and other counterparties.

If the TBTF banks valued simplicity, they would not have an average 2,000 separate affiliates. Regulators would not have consigned the living wills of 11 banking behemoths to the graveyard last year, labeling them "not credible."

And if the TBTFs valued transparency, they would not have pushed through an extortionate amendment to the Dodd-Frank Act last year allowing them to reap the financial benefits of having their high-risk derivatives activities insured by the taxpayers. (Full disclosure: just as Citigroup wrote the legislation granting it relief from Dodd-Frank, I had a hand in crafting HR 888. Big difference — I get no financial gain from my services.)

Measuring these financial benefits is the starting point for the Subsidy Reserve Act. But big banks and their supporters state that the TBTF subsidy has already been greatly reduced or eliminated, citing a 2014 study by the Government Accountability Office as evidence.

There are several issues with the GAO study. The GAO was asked by two senators of opposite parties to study the "financial benefits" flowing to the TBTFs because of government support. For whatever reason (some suspect lobbying influence), the GAO reported not on the financial benefits flowing to the TBTFs, but on the much narrower issue of their "funding advantage." The study therefore failed to take account of the financial benefit of conducting their swaps business with the taxpayer backing of the Federal Deposit Insurance Corp. There are many other financial benefits that GAO failed to consider.

But even the scaled-back GAO study is very much a minority view. It flies in the face of what regulators, bankers and the public know to be a substantial subsidy going to the TBTFs. They are bigger, more complex and pose greater risk to the financial system than they did before the crisis.

If, in fact, there are no financial benefits to being TBTF, then big banks have nothing to fear from HR 888. Why? Because the Fed, after a thoroughly transparent process calling on the best minds in government, academia and industry, will reach that conclusion itself. Let the chips and the facts fall where they may!  

Last week, Sen. Elizabeth Warren grilled Federal Reserve Chairman Janet Yellen about her general counsel Scott Alvarez. Alvarez had popped off about the lucrative repeal of derivative provisions of Dodd-Frank.

While Alvarez’s views may be of interest to some, the more compelling questions Warren should have asked are: "Has the Fed measured the financial benefits that the TBTF banks receive by shifting the risk of these activities onto the backs of the U.S. taxpayers? And if not, why not?" I suspect each TBTF has already made the calculation of the financial benefit it derives from conducting swaps in its federally insured bank.

It’s time for follow-up hearings on these questions — and on HR 888. As long as we allow the banks to hide their TBTF financial benefits, the statute’s mandate will never be achieved.

Professor Cornelius Hurley is the director of the Boston University Center for Finance, Law & Policy. Follow him on Twitter at @ckhurley.