Regulators say they've solved the "too big to fail" problem. Clearly they've fallen prey to wishful thinking.
The Dodd-Frank Act seeks to protect the financial system from the failure "too big to fail" banks, thereby reducing the need for future taxpayer-funded bailouts. Recently, the Federal Deposit Insurance Corp. and the Richmond Federal Reserve announced that the law's living wills and orderly liquidation provisions have substantially reduced the risk of another taxpayer-funded bailout. They assert that TBTF institutionsmay be safely unwind without unduly damaging the financial system.
In reality, these are what the sociologist Lee Clarke calls fantasy documents rhetoric directed at a public that wants reassurance that there is no risk of future disaster. Self-interested statements agencies base their findings on a selective reading of the evidence. In addition, regulators naturally have behavioral biases that lead them to be overconfident about their achievements and hold onto the illusion of control.
Regulators have limited knowledge of the risks facing major banks, as the London Whale scandal and continued slew of big-bank settlements illustrate. So they are forced to rely on the honor system: they ask banks to tell them in their living wills what could go wrong and how they would unwind. Unfortunately, senior managers at these institutions may be less than forthcoming. Furthermore, they may lack knowledge of the risks they face.
Moreover, there are important practical concerns with regulators' reliance on the orderly liquidation provision. Putting aside serious legal issues that are unlikely to be resolved until the provision invoked during the next crisis, there is the question of what entity is large enough to absorb the assets of a liquidating TBTF bank. The only plausible options are the federal government (taxpayers) or another big bank. If the latter, the concentration of assets in the financial system increases further aggravating the TBTF problem. This is what happened with the arranged marriages between Bear Stearns, Washington Mutual and Merrill Lynch with JPMorgan Chase and Bank of America during the financial crisis.
In addition, as we saw in the last crisis, TBTF banks rarely fail in isolation since they are so interconnected. This is confirmed by an April report from Kroll Bond Rating Agency, which makes the point that 40% of the top 10 banks essentially failed during the crisis, requiring government intervention or a stronger institution to rescue them. While it might be possible for regulators to handle one major failure next time around, does anyone believe they can handle the simultaneous failure of two or more TBTF banks?
Even if one does believe this is within reach, surely it's unwise to endanger the financial system by taking the chance that regulators might be able to work things out if all goes according to plan. If a TBTF bank collapses, government intervention is still needed to do what markets are unable to do: provide liquidity and take risk.
The major lesson here is that the TBTF problem can't be solved with living wills and orderly liquidation. Rather, a structural solution is needed to reduce the size of mega-institutions especially the big four of Citigroup, Wells Fargo, JPMorgan Chase and Bank of America, each with assets exceeding $1 trillion. These institutions now represent more than 40% of banking assets in the U.S. financial system, according to the FDIC. The failure of any one of these institutions would endanger the economy.
Despite these facts, there is limited political will for a structural solution at this time. Thus regulators are resorting to fantasy documents to cover up the problem.
Regulatory fantasy documents are not just ineffectual they're also dangerous. Efforts to prevent future crises suffer if regulators and government officials mistakenly believe they can adequately deal with TBTF failures. Worse yet, regulators' unwarranted confidence could lead Congress to further curb the Fed's emergency lending powers, as Richmond Fed president Jeffrey Lacker recommended in a recent speech. This would be disastrous, since bailouts will remain the only possible option as long as megabanks exist.
It is a fools errand to try to limit the uncontrollable damage of a TBTF failure. Either eliminate the threat entirely through a breakup of TBTF institutions or accept the need for taxpayer-funded bailouts. Hubris and magical thinking will not make the problem disappear.
J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.