'Too Big to Fail' Is a Distraction

Amid Washington's legislative gridlock, a desire to break up the nation's megabanks has lit a small flame of bipartisanship.

The group's right wing includes Federal Deposit Insurance Corp. director Thomas Hoenig, Federal Reserve Bank of Dallas President Richard Fisher and, most recently, conservative columnist George Will. On the left, promising a new bill on the topic co-sponsored by Sen. David Vitter (R-La), is Senator Sherrod Brown (D-Ohio) as well as economist Simon Johnson and others.  Since "bipartisan" doesn't necessarily equal "better," this unlikely alliance is based on some shaky assumptions. And the size fetish is obscuring a meaningful inquiry into the real causes of systemic risk.

Assumption 1: The failure of a TBTF firm will result in a systemic crisis.

Despite the ongoing preoccupation with the Lehman bankruptcy, no single bank failure "caused" the 2008 financial crisis. Instead, as economist Anna Schwartz noted (somewhat presciently) in 2008, the crisis was fueled by a marketwide loss of confidence in the balance sheets of many institutions, all holding similar assets – a phenomenon now called "contagion."

Now a megabank failure could pose a systemic risk, but this risk is purely operational. If the bank's core functions are disrupted, the concern is that money won't continue to flow through the system. Pre-2010 there was no coordinated liquidation process for financial "supermarkets," then subject to a variety of contradictory bankruptcy regimes.

Although Dodd-Frank's orderly liquidation provisions are imperfect, vague and likely give unconstitutional powers to the Treasury secretary, the FDIC has made great strides in developing the single point of entry recapitalization for megabanks. This allows creditors of the failed firm to be converted to equity holders at the holding company level. It wipes out existing equity holders, allowing the subsidiary operations of the bank to continue temporarily without taxpayer assistance. Temporary recapitalization addresses the moral hazard concerns that Hoenig and Fisher have raised because creditors and equity holders, who credibly believe they will be wiped out in a megabank bankruptcy, will not assume an implicit government guarantee and will tailor behavior accordingly.

Assumption 2: TBTF firms have a funding advantage over non-TBTF firms.

The pro-downsizing camp argues that firms deemed TBTF secure a funding advantage over non-TBTF firms because creditors and depositors are more willing to lend to firms that are subject to a government backstop, whether real or perceived. Proponents have also argued that this backstop results in TBTF firms securing higher ratings at the company level and on their public debt, allowing them to borrow more cheaply.

To date, the studies on this topic appear too generalized and speculative to be credible – even Senator Brown asked the GAO to investigate the claim. Additionally, if the funding advantage does exist, it is difficult, if not impossible, to discern whether it was created by an implicit government guarantee or because larger firms finance their activities more cheaply due to size, funding mix and other scale economies.  The only thing we can say for certain, as I have noted previously, is that community banks are subject to higher funding costs when compared to banks holding in excess of $10 billion, a category much broader than TBTF institutions.