Too Big to Fail

The financial crisis uncovered a number of fundamental flaws in our financial system. These flaws span a wide spectrum of financial activities and include (to name just a few) reckless mortgage underwriting, an overdependence on ratings agencies, a massive increase in derivatives (and corresponding counterparty risk), insufficient bank capital and liquidity requirements, speculative proprietary trading by banks, legislative policies encouraging home ownership, and ineffective regulatory supervision itself. Smart people disagree about the extent to which these issues had and continue to pose a systemic risk to the global financial system. To varying degrees, each of the aforementioned risks is being addressed through ongoing regulatory initiatives. However, the one glaring elephant in the room remains the risk posed by financial institutions that are “too big to fail”, or “TBTF”.

Nearly everyone agrees that rather than addressing the problem of TBTF we have simply made it worse. According to research analysts at Barclay’s Capital, “the top 20 banks control a full 62% of the U.S. deposits currently versus 46% in 2003 and 38% in 1998.” Perhaps more astoundingly, Barclay’s writes, “The total market cap of the top 25 banks is more than 17x larger today than it was in 1990. It is also 20% above 2007’s pre-crisis levels.” It’s hard to argue with these numbers. As we like to say in the finance world, “the numbers are the numbers.”

To date, the approach by regulators to reign in the risk of TBTF has been to require higher levels of capital and liquidity at banks deemed “systemically important financial institutions”, or “SIFIs”. There is also a provision within the Dodd-Frank Act called Orderly Liquidation Authority (OLA), which outlines a process whereby regulators will be able to place failing SIFI’s in receivership so that they may be liquidated while minimizing the risk to the financial system. Despite valiant efforts, though, higher capital requirements and the OLA are unlikely to be the comprehensive solution everyone is looking for. It is highly unlikely that any type of SIFI liquidation, whether it be in receivership or not, would be an easy task. The high degree of interconnectness among our large financial institutions ensures that this process would have many negative consequences for the global economy. The “Orderly” in OLA is a misnomer.

Perhaps the best excuse for the failure to address the TBTF problem is the fact that it would likely be highly disruptive to the economic recovery. We are, after all, in the midst of recovery from the worst downturn since the Great Depression. We strongly suspect that one of the factors inhibiting a stronger recovery has been the massive amount of new regulatory initiatives imposed on the banking industry. Banks have been distracted by litigation and capital requirements when they should be making loans that will help create jobs. In other words, effectively addressing TBTF would undoubtedly reduce already weak credit flows.

When viewed in this light, the inaction with regard to the TBTF problem is analogous to the response to the problem of too much debt in the economy. Rather than go through the needed process of deleveraging, the Fed remains intent on suppressing interest rates in an effort to encourage consumption rather than saving. Effectively, the Fed has encouraged debt as a response to the problem of too much debt. With regard to the TBTF problem, regulators have encouraged and blessed bank mergers as a way of avoiding financial contagion. In the process, however, the Fed has also inadvertently created a handful of monoliths as important to the health of the economy as any other entity. Brilliant, right?

Most worrisome in the TBTF discussion is something I’ve discussed for five years and that is the lack of a clear, articulate description of what the US banking system should look like. For all of the supposed leadership from those with regulatory and legislative responsibility, we have heard complex proposals to address TBTF by restricting access to future bailouts and even a progressive tax for the increased supervision that larger and larger institutions demand. BUT, we have yet to hear a description of the banking Eden to which we are being led. What’s the proper size restriction for a US bank? Will they be allowed to fail or will they be bailed out yet again?

Most important as we address TBTF is having a clear vision with Hamiltonian thoughtfulness that describes the banking system best suited to a democratic, capitalistic, free-market United States that will function, survive, and grow for the next few hundred years. Once done, whether through the reinstitution of Glass Steagall or some other legislation, our economic and fiscal house will rest again on solid ground and be prepared to flourish. It is imperative that we address the issue.