The single most important lesson we should have learned from the financial crisis is that a handful of giant entities are simply "too big to fail" and must be bailed out to avoid catastrophic results.
We learned this the hard way when our financial regulatory brain trust of Henry Paulson, Ben Bernanke and Tim Geithner made the biggest mistake of the crisis by failing to bail out Lehman. While these former U.S. authorities especially Bernanke have argued that such a bailout was not possible, anything and everything should have been done by Treasury and the Federal Reserve to avoid Lehman's disastrous outcome. With what would have been an estimated $65 billion bailout, we could have likely saved an estimated few trillions of dollars in damage to financial markets and the economy.
After watching our system nearly go over the cliff with the Lehman bankruptcy, our Beltway bureaucrats finally "got it" and began bailing out systemic private and public entities. Even then, they acted in a painfully slow and perilous manner, doing too little, too late.
The failure of Wachovia Bank, then the country's third-largest banks by deposits, was a case in point. To this day, the Federal Deposit Insurance Corp. is in denial about classifying Wachovia as a failed bank. However, I knew there was no hope for the bank the day I tried to make a withdrawal from my Wachovia branch in Miami, and was politely told I had to go to another branch because they had "run out of cash"!
Had Wachovia's liquidity crisis been made public, the lines of people waiting to withdraw funds from IndyMac would have been nothing compared to a bank run on Wachovia, which had more than 3,300 offices with $450 billion of deposits in 21 states in June 2008, according to the FDIC.
Good public policy requires immediate and unlimited government assistance of TBTF banks to avoid any possibility of contagion. At the risk of oversimplifying a very controversial issue, there are at least four facts of life when it comes to TBTF:
- TBTF has existed since 1984 with the bailout of Continental Illinois.
- TBTF cannot be eliminated because of the possibility of contagion.
- TBTF is an extremely valuable competitive advantage to those in this exclusive club.
- TBTF banks pay nothing for this privilege.
Realizing that nothing can be done about the first three facts, the FDIC should impose a special TBTF assessment on top of regular risk-based premiums so that big banks will pay for the privilege and the additional risk they generate for the FDIC deposit insurance fund. These banks are already benefiting from being TBTF; at least under my proposal, they will pay for it. This would also avoid imposing a punitive size-based tax on banks; instead, the riskiest TBTF banks would be the ones with the largest assessments.
I made this recommendation in testimony before the FDIC and Congress in 1995 and 2000. The big-bank lobby, however, made sure it went nowhere. Why pay for something they get for free?
Perhaps they will rethink their position in the face of public outcry over TBTF banks as well as other proposed fixes including increased capital and liquidity requirements, living wills, stress tests and the Volcker Rule. I call these measures "regulatory opiates" because they make regulators, Congress, and the public feel reassured that something is being done to prevent the next crisis, regardless of whether the fixes actually work. Frankly, I take little comfort in the fact that our current crisis policies were formulated by most of the same Washington experts who failed to prevent the last crisis and actually made it worse.
Just in case none of these proposed solutions work, some politicians and others have resorted to calling for a breakup of the country's biggest banks. But the size of these big banks has allowed them to pour resources into developing innovations like travelers checks, compound interest, negotiable CDs, ATMs, and online banking, not to mention pioneering community development activities.
Moreover, size matters in the global financial markets. American banks were once the dominant force in global markets. Today, only one American bank (JPMorgan Chase) ranks in the top 10 biggest banks by assets, with four of the five largest in China. The U.S. continues to lose financial ground to other countries. But the continued existence of big banks ensures that we remain competitive and have a seat at the world banking table.
It's true that big banks can cause big problems and require big bailouts. But while I dislike bailouts, I dislike contagion even more. The former is the lesser of these two evils. The moral hazard inherent in TBTF can be reduced by wiping out shareholders and creditors, imposing mandatory clawbacks and prosecuting culpable managers and directors.
A TBTF assessment that assures more bailout funds come from big banks themselves is an example of smart regulation as opposed to over-regulation or reregulation. A truly risk-based assessment does not significantly disrupt our current banking system by dismantling or crippling our big banks. It does, however, immediately impact their profits. That's how you get big-bank chiefs and their boards to change their risk profile and behavior, rather than experimenting with untested and potentially ineffective or damaging fixes.
Kenneth H. Thomas, an independent bank consultant and economist, was a lecturer in finance at the University of Pennsylvania's Wharton School for over 40 years.