Why the 'Too Big to Fail' Problem Just Won't Die

Many of the largest banks in the U.S. have only grown bigger and more complex in the years since the financial crisis. Therefore claims that the country has made major strides toward ending "too big to fail," such as those voiced by The Clearing House Association president Paul Saltzman in a recent opinion piece for BankThink, should be closely examined.

The majority of the world's 30 largest banks are now larger than they were in 2006, as Stanford University finance and economics professor Anat Admati said at the World Economic Forum in Davos. Eight of these banks are headquartered in the U.S. Many of these banks, in their never-ending search for yield, have become more complex by increasing their repurchasing activities, investments in securitizations and derivatives transactions.

Banks can afford to do this because, unlike other "perfectly successful companies which fund themselves with plenty of equity, banks have a distorted business model which enables them, by being excessively leveraged, to pass more costs to others," as Admati told me Thursday.                                                

Yet Saltzman's column contends that the public should be reassured by a recent Government Accountability Office study, which concluded that any advantage large banks receive due to market perceptions had been significantly reduced or reversed. However, the GAO study focused specifically on TBTF banks' funding costs — not the numerous financial benefits that taxpayers subsidize, such astheir ability to book derivatives in their federally-insured banking entities with more favorable terms than non-banks.

Moreover, as I have written in these columns, measuring the TBTF subsidy precisely is very difficult because there a number of possible methodologies. The GAO report also mentioned this point.

In addition, the implicit subsidy that big banks enjoy is cyclical. Right now, with the U.S. economy performing better than it has since the financial crisis, it is unsurprising that the perception of government bailouts may have decreased. But in the next downturn, market perception of a subsidy would reappear.

Saltzman highlights new regulatory capital and buffer requirements that are intended to take aim at TBTF. But most of these rules have yet to be implemented. We won't really know how well the rules work until they've taken effect, and many big banks are likely to struggle to implement them.

The column also says that banks are required to "hold more capital," a phrase that can be misleading. Capital is not a cookie held in a jar. It refers to funding — ideally retained earnings or shares of equity — that can be invested but that does not lead to distress or insolvency when unexpected losses occur. As Admati says, "the use of [the phrase] 'hold capital' leads to confusion between the asset and liability sides of the balance sheet."

Banks' opacity gives more reason to worry about the effectiveness of new capital rules. Investors, not to mention taxpayers, do not know what credit, market, and operational risk inputs banks use to calculate risk-weighted assets, which is the premise for the majority of Basel III. Recent Basel Committee bank risks disclosure requirements could go a long way in improving market discipline, but those rules have not yet been implemented in any country. 

Moreover, a significant majority of the world's biggest banks are unlikely to be able to meet important data aggregation requirements by the 2016 deadline set by the Basel Committee. The point of these requirements is to improve banks' risk management practices and bolster their risk data, which would help smooth banks' decision-making processes as well as their resolutions if the banks were to fail. But half of the biggest banks have rated themselves as "materially non-compliant" when it comes to their data accuracy and integrity, and the other half might well be overly optimistic. This means that many banks' risk management practices, not to mention their capital ratios, cannot be trusted.

Saltzman also notes Dodd-Frank's orderly liquidation authority and the Financial Stability Board's total loss-absorbing capacity proposal as steps toward ending TBTF. But the FSB has no legal or enforcement powers. If different bank regulators decide to accept the proposal, TLAC could become a required regulation — but right now it's just on the FSB's wish list. And it is worth noting that there is a full-scale global assault to weaken the TLAC proposal. The Clearing House is among the organizations pushing to lower the TLAC requirement.

The column also neglects to mention that U.S. regulators have found the living wills of 11 of the largest U.S. banks to be inadequate. We cannot trust that big banks know how they would resolve themselves in an orderly manner in domestic and global jurisdictions without government bailouts.

Finally, it is important to point out the incredibly high level of operational risk that continues to plague TBTF banks — as evidenced by the millions of dollars that banks have paid to settle accusations of manipulating interest rates, foreign exchange rates and commodity rates, as well as charges related to money laundering, terrorism financing and erroneous foreclosures. What part of this unethical behavior should lead us to believe that the biggest banks respect new regulations?

I would be remiss not to say that I do agree with one point Saltzman makes: indeed, "more needs to be done" to end TBTF.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. Follow her on Twitter at @MRVAssociates.