When it was enacted, the Dodd-Frank Act was advertised as the answer to the too-big-to-fail problem: the threat of taxpayer bailouts because the government is unwilling to let a large bank fail.
But the law is not a viable solution, and some other ideas — such as breaking up the biggest banks — are not workable either. In reality, fixing TBTF is a waste of time. The right policy is to ensure that the largest banks are never in trouble, and that means adopting a simplified assets-to-equity "leverage" ratio and an improved system of prompt corrective action for the largest banks.
Let's look at some of the problems with the current TBTF debate, which overlooks certain key facts. First, serious questions hamper the government's ability to implement the primary Dodd-Frank section addressing TBTF, known as Title II.
Title II allows the Federal Deposit Insurance Corp. to resolve a systemically important financial company. But, as I point out in a paper with my AEI colleague Paul Kupiec, that title applies to nonbank financial firms, and bars the FDIC from placing a large bank subsidiary in its own Title II resolution.
That leaves the FDIC with two bad options. The FDIC can resolve a subsidiary bank through the Federal Deposit Insurance Act. But to take over and resolve a failing bank requires the FDIC to tap the Deposit Insurance Fund, which would be insufficient to resolve a trillion-dollar institution. Also, in bank resolutions, the FDIC typically sells the failing bank to a healthy acquirer. If we are really worried about TBTF, selling a trillion-dollar bank to another trillion-dollar bank isn't the answer.
In the second option, the FDIC deals with the subsidiary bank under a Title II resolution of its parent. But the FDIC's "single point of entry" strategy — the agency's most-discussed method for implementing Title II — is also unworkable for the largest banks. Under SPOE, the FDIC would close the holding company and use its assets to recapitalize the bank, keeping the bank operating. However, Title II makes clear that this can be done only if the holding company is insolvent.
If the bank's failure was the basis for triggering Title II, legal questions would likely arise about whether the holding company had failed. Regulators would likely cite the "source of strength" doctrine, arguing in effect that a bank failure equals that of the holding company, but the legal basis for that doctrine is unproven. And, as Kupiec and I point out, holding companies for the largest banks have other profitable subsidiaries, allowing them to remain solvent even if their largest bank failed — meaning the FDIC will not be able to use its SPOE strategy for the very banks that create the TBTF problem.
Nor can we solve TBTF by breaking up the biggest banks, as some commentators have urged. In practical terms, a bank is only TBTF if the Federal Reserve believes its failure will have systemic effects. But since no one can know how the Fed will act in a future situation, it's silly to suggest that the largest banks should be reduced in size until they are no longer TBTF. It is impossible to know what that size is.
Finally, consider this: our four largest banks have total combined assets of approximately $6 trillion. If we arbitrarily decide that $250 billion is the right ceiling, we could break them up into in 24 separate $250 billion banks. What happens then if one of them fails? It can't be sold to one of the others, because the acquiring bank would then be larger than the limit. Nor could any other existing bank—of any size—merge with it. So the FDIC would have to take over the failing bank and resolve it by selling off the pieces to whatever other banks could buy them without violating the $250 billion ceiling. It would take years—even if the FDIC had the funds and the technical ability to operate the bank while selling off its assets. Meanwhile, the losses to the taxpayers and disruption in the economy would be substantial.
So what are we to do? We have four trillion-dollar banks, and many others much larger than the $250 billion size we arbitrarily chose. The failure of any could cost the taxpayers billions and seriously disrupt the economy, and there is no practical way to address this problem under existing law. We can't break them up without assurance that their parts won't still be TBTF—in the eyes of the Fed—at whatever level is chosen; they can't be merged with a healthy bank without making the healthy one even more TBTF; and the FDIC doesn't have the financial resources to resolve them if they fail.
The answer is that these very large banks cannot be allowed to fail. That sounds impossible, but it's not. Their capital level can be increased substantially, and backed up with an effective system of prompt corrective action and continuous examination. Prompt corrective action hasn't worked well for small banks because they are not widely diversified and can lose substantial capital between examinations. The largest banks, however, are examined on a continuous basis, and their diversification is further protection against unforeseen events.
A thoroughgoing reform like this would abandon the risk-based capital system — a complex and nontransparent way for governments to measure banks' capital. In its place, we should substitute a leverage ratio — the simpler the better. A non-risk-based capital ratio is already a component of the international Basel capital regime, but it should be the only component. A risk-based capital system allows too much room for error and manipulation. It can even become a form of credit allocation. For example, before the crisis, private mortgage-backed securities were considered low risk, meaning banks would set aside less capital to cover loss in a risk-based system. But that was a recipe for disaster.
On the other hand, data shows that investors and creditors reward a high equity-to-assets leverage ratio, probably because they have confidence that the banks' capital is real and not simply a gaming of the risk-based capital system.
The traditional objections to higher capital requirements are that they would encourage greater risk-taking (to raise return on equity) or higher lending costs (to cover capital costs). But a credible leverage ratio will attract financing at lower cost, increasing return on equity. Excessive risk-taking would be counteracted by continuous examination and prompt corrective action to spot problems before they significantly diminish a bank's capital cushion.
Given that there is no other viable solution to the TBTF problem, let's try this one.
Peter J. Wallison is a senior fellow at the American Enterprise Institute. His most recent book is "Hidden in Plain Sight: What Caused the World's Worst Financial Crisis and Why It Could Happen Again."