It is well documented that "too big to fail" banks and nonbanks enjoy a substantial taxpayer subsidy in the form of lower borrowing costs. As a result, TBTF firms have morphed into latter-day versions of Fannie Mae and Freddie Mac, absent the public mission those twins hide behind. Despite its rhetoric, Congress has not come to grips with the issue.
The truth is that we cannot allow our largest financial institutions, five of which control over 50% of the country's financial assets, to fail. The economic impact would be devastating.
There is a solution. But it has nothing to do with the growing calls to break banks into smaller, less threatening pieces, or the debate raging over whether to establish a $50 billion slush fund to cover future resolutions of TBTF firms.
The trouble with the break-up solution is that no one knows how it would be achieved and there is no political will to implement it. As for the $50 billion prepaid slush fund, both sides are right. Yes, it would help pay for a TBTF failure in the future and, yes, it would increase moral hazard by enabling current TBTF firms and TBTF wannabes to take on more risk and further jeopardize the economy and taxpayers.
The solution we are proposing is one that all sides can embrace. It balances the two pillars of democratic capitalism — regulation and market discipline. It places the ultimate fate of TBTF firms in the hands of their shareholders while protecting the financial system from the contagion effects of future TBTF meltdowns.
First, identify the handful of TBTF institutions. Largely, the regulators and the credit rating agencies have already done this (Goldman, Citigroup, UBS, etc.).
Second, require each TBTF firm to establish a separate reserve account on its balance sheet consisting of some or all of the annual taxpayer subsidy it enjoys as a result of its privileged status (we call it a "subsidy reserve"). Treated as capital for liquidation purposes but not for regulatory purposes, this reserve would be easily calculated based on the "support" versus "stand-alone" ratings currently assigned by credit rating agencies.
Third, require that the subsidy reserve accumulate indefinitely, including the earnings on the reserve.
Fourth, provide that the subsidy reserve can be transferred to shareholders or others only in the form of spinoffs of companies or divisions; it cannot be paid out in the form of dividends. In other words, the only way the value of the subsidy reserve can be unlocked is through downsizing the firm. In relatively short order the TBTF firms will be carrying very large reserves, which will be available for use only in the event of a firm's failure.
The accumulation of reserves, combined with higher capital and liquidity requirements imposed by regulators, would lead to shareholder demands that such reserves be more efficiently utilized. Managements and boards of directors faced with such demands would have two choices.
They could continue business as usual, in which case the subsidy reserve plus capital will accrete to the point where the firms actually become "too safe to fail." This will be reassuring for taxpayers but will result in relatively low returns on investment for shareholders.
Or, they can shrink the firms by divesting subsidiaries or spinning off divisions to shareholders. In this process, the subsidy reserve will be allocated to the newly divested entities. Divest enough and the firms are no longer TBTF and are no longer required to post the subsidy reserve.
Among the pernicious effects of TBTF as unleashed in 2008 is the ongoing wealth transfer from taxpayers to the TBTF firms. The TBTF discount distorts the capital markets, artificially dividing the markets in two: TBTF firms and all others.
The shareholder-driven ap-proach we are proposing is one that politicians and bankers of all stripes can get behind. It is self-policing, and it can be readily adopted on a global basis.
Unlike the bills currently under consideration in Congress, the subsidy reserve will actually bring an end to distortions caused by TBTF. Best of all, it will be the markets, not central planning in Washington, that determine the winners and losers.