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'Too Big to Fail' Is a Distraction

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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.

Furthermore, threatening private firms with potentially destructive action is not the answer to a government-created funding advantage, if one indeed exists. That is like treating an innocuous symptom and ignoring the serious underlying disease. Prior to 2008, proponents argue, the firms now considered TBTF had no discernible funding advantage. To the extent this advantage now exists, it is a post-2008 creation based on a perceived government backstop – a self-fueling monster that came to life. 

Dodd-Frank's systemic provisions codified a problem that began with the Treasury's haphazard response to the crisis. (And using the label outside of the banking sector for firms and functions that are clearly not systemic only exacerbates it.) A credible megabank liquidation regime is just as effective in removing this perceived advantage as downsizing the firm, with fewer economic consequences.

Assumption 3: Systemic risk can be addressed at the firm level.

Systemic risk is created by the concentration of risky assets. It is a market, not a firm, issue. Unfortunately, many of the post-2008 fixes to the financial market are resulting in more, not less, asset concentration. For example, Basel III's risk-weighting rules encourage banks to concentrate holdings in the sovereign bond market. And when the bond bubble eventually bursts, this will place considerable stress on all banks, regardless of size. (Let's not forget mortgage-related products' long history of preferential regulatory and capital treatment, perhaps explaining why banks had so many of them on the books in 2007.)

Assumption 4: Reinstating Glass-Steagall will address TBTF.

Glass-Steagall cannot address size because it never was about size. The prohibition on the affiliation between commercial and investment banks was rooted in a belief that riskier underwriting and trading activities undermined traditional commercial banking. This sounds reasonable, except that if the 2008 financial crisis proved anything, it was that the more diversified the activities and assets of a bank, the better it will perform when things go wrong. And the loan origination problems at the heart of the subprime mortgage crisis suggest that making loans is just as risky an activity as trading the securities that the loans collateralize.

Assumption 5: U.S. banks are dangerously and unnecessarily large.

The U.S. produces 25% of global GDP. Yet its largest bank ranks only 9th in the world in total assets and will likely drop down the list in the coming years if China and Brazil's megabanks continue their march to supremacy. If the U.S.'s largest banks are downsized, there are plenty of foreign institutions willing to step in and fill the void. Suggesting that there are no economies of scale in banking is like arguing that Walmart has not provided cheaper products to consumers.

While smaller banks may play an important function at the local level, they simply cannot provide all the services that megabanks do and consumers will lose out. Senator Brown's concern for community banks is touching. But even community banks would argue that they are far better served by removing the crushing regulatory weight they have endured since 2008 than by breaking up the megabanks.

Oscar Wilde once noted, "Whenever people agree with me I always feel I must be wrong," a maxim Hoenig, Fisher and Will should remember before throwing their collective weight behind Brown's proposal. It's time to acknowledge that breaking up the nation's megabanks will not herald a new Golden Age where market discipline reigns supreme. TBTF is a mythical creation of our own making. The fear, at least, is real.

Louise Bennetts is associate director of financial regulation studies at the Cato Institute.

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Comments (14)
Another Wall Street spin machine article. I guess American Banker has now become the "spin machine" voice for Wall Street. It appears that the American Banker will print any article from any apologist for Wall Street. aybe the American Banker should consider a name change to the American Wall Street Banker?

Louise Bennetts uses sylogistic logic to support her flawed arguements. Her theses require the willing suspension of disbelief. Having lived the crisis, seen that reality, I choose not to suspend my disbeliefs. As much as Wall Street and their shills like Bennetts want us to believe that TBTF/TBTJ does not exist or if it does it is no threat, the reality is that the financial crisis DID happen and the largest banks DID fail and had to be bailed out by the nation's taxpayers and their failures DID cause massive disruptions to our nation's citizens and to our economy overall - to the tune of $13 trillion dollars. And we should never, ever allow that kind of wanton damage to happen again. as much as Bennetts and others who carry water for Wall Street wish it weren't so, TBTF is a disease on the body financial that must be eradicated before we truly have free markets again. I am firmly in the Hoenig, Fisher, Simon, Will, Lacker, George and Willmarth camp.
Posted by commobanker | Wednesday, March 06 2013 at 11:51AM ET
Forcing banks to downsize is like a sex change operation: it isn't the same as elimiting the incentives for them to get TBTF in the first place. That said, while Lehman's failure didn't cause the financial crisis, how did it survive so long that it returned less than 20 cents on the dollar in an orderly liquidation. Knowing that, Chairman Bernanke still said he would have bailed it out if he could.
Posted by kvillani | Wednesday, March 06 2013 at 12:03PM ET
The first comment above is typical of the "break them up crowd": a mix of name-calling and emotion-induced trite phrases with no factual basis for the argument before us. The too big to fail phenom has its basis in the bailouts of the 1970s and 1980s. Those interventions sent the signal that if you were one of the top 20 banks and approached failure you would get a bailout, which in part led to the funding advantage discussed in the article and the consolidation of the industry into few, bigger players. The answer should have been to allow the TBTFs to fail during 2008 and 2009 and break them up by auctioning them off. But Paulson, Geithner, Bernanke and Bair made the mistake of bailing them out and propping them up allowing them to linger on until the next crisis (think Continental Illinois/Bank of America bailed out in the 1930s, 1980s and 2000s). The idea of handing the power to break up the banks and getting them down to some vaguely defined "optimal size" to the supervisors and regulators that completely failed at their job of acting as an early warning system during 2008 and 2009 shows how detached the break them up crowd is from reality.
Posted by Vern McKinley | Wednesday, March 06 2013 at 12:31PM ET
Wow, it's easy to see how the Koch assertion of dominance over the once-proud Cato Institute is working out. The point of Glass-Steagall was to keep insured banks from using deposits to fund merchant banking and investment banking. That is the exact problem that mega-banks create, as we learn from the failed London Whale Trade. Why should the FDIC have to support risks behind the $70 trillion plus derivatives portfolio? Or is our writer so sure that the counter-parties to all these transactions will pay when the collateral calls start up? As to size, study after study shows that there are no economies of scale in banks beyond $100 billion except those arising from the perception that they are too big to fail. Apparently it's quote day, so here's H.L. Mencken: "The average man does not get pleasure out of an idea because he thinks it is true; he thinks it is true because he gets pleasure out of it."
Posted by masaccio | Wednesday, March 06 2013 at 12:50PM ET
While I agree with Ms. Bennetts' assertion that TBTF is a term created out of fear, we have yet to have a meaningful discussion on the potential for calamities that can develop and occur in highly-complex enterprises totally out of eye-sight and ear-shot of the c-suite (and regulators).

The London-whale episode was a complete breakdown in the governance and management processes at the very-large institution where it occurred. The CEO/CFO/CRO should have had a clue of what was brewing within the organization they managed. This near-miss didn't occur because they were simply large; it occurred because their management processes were not appropriate for their size and diversity of business operations. And these too-big-to-govern scenarios can, and do, occur in institutions considerably smaller than $1T in assets.

Breaking up so-called TBTF institutions is a cop-out. Let's focus some more attention to resolving the unique challenges of governing large institutions.
Posted by louisnyc | Wednesday, March 06 2013 at 12:54PM ET
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