How to Fix Too Big to Fail

by Ammon Simon
Dodd-Frank didn’t end it, but we still can.

Three years after the passage of Dodd-Frank – a law that was supposed to permanently end the massive publicly funded bailouts of 2008 – it’s clear that the discredited and unpopular practice of unofficially treating certain institutions as “too big to fail” is alive and well.

Under the theory of Too Big to Fail (TBTF), which was invoked during our most recent financial crisis, governmental assistance to large failing financial institutions is necessary because their failure would be catastrophic for our economy. 

The idea is unpopular in part because it justifies subsidizing the very Wall Street institutions that played a part in the financial crisis. Worse yet, if TBTF stays around, big financial institutions will become riskier and risker, possibly even triggering the next major meltdown.

The evidence for TBTF’s continued existence is wide-ranging. Our financial system has become increasingly concentrated: By 2011 the five largest banks held 48 percent of U.S. banking assets, up from 30 percent in 2001. The largest bank, JPMorgan Chase, reached about 14 percent of our banking system’s total assets. The financial markets give larger banks cheaper access to credit, probably owing to the likelihood of public bailouts otherwise. One estimate found that this subsidy amounted to around $83 billion a year. Beyond that, statements by our political elite, such as Treasury secretary Jack Lew, Fed chairman Ben Bernanke, and many other policymakers, all seem to acknowledge TBTF.

TBTF helps large banks at the expense of community banks, which are essential to our economy. By making failure less common, it creates moral hazard (the subsidization of bad behavior) in our financial system. 

In a normally functioning market, mismanaged firms pay more to borrow money and raise equity, because lenders demand a higher return to make up for the perceived risk. This pressure puts “market discipline” on firms because it encourages them to reduce their perceived riskiness and avoid those costs.

TBTF undermines this because investors come to believe that the government will bail out a large failed financial institution for fear of the calamitous consequences. When the possibility of loss is eliminated, a firm’s riskiness becomes essentially irrelevant to lenders. 

The dynamic also gets in the way of creative destruction, the healthy economic churning brought about by failure.

These costs are widely accepted. Where opinions diverge is on what to do about TBTF. Have certain elements in Dodd-Frank effectively addressed this problem? If not, will they? Should conservatives embrace breaking up the big banks as an alternative? If not, what can we do about the problem?

Dodd-Frank’s defenders frequently cite two of its creations — the Orderly Liquidation Authority (OLA) and the Financial Stability Oversight Council (FSOC) — as a main solution to TBTF. Neither offers a sound path to ending the problem.

In short, the Orderly Liquidation Authority, under Title II of Dodd-Frank, authorizes the FDIC to set up receivership — self-funded through FDIC fees, apart from congressional appropriations — for failing financial institutions deemed to be systemically important. At least officially, these financial institutions must be liquidated.

As Columbia Law professor Thomas Merrill has explained, there is only nominal judicial or congressional oversight over the OLA, and the public won’t know about a liquidation until it’s begun. The FDIC’s new draconian power will be dictated by the rule of politics, not the rule of law (see the GM and Chrysler bankruptcies). Not only does this unaccountable power create significant economic uncertainty, it also poses real constitutional problems, which is why it’s now the subject of a legal challenge.

Of course, an unconstitutional law could still theoretically end moral hazard and TBTF, and Dodd-Frank does officially end certain kinds of bailouts. The OLA’s liquidation requirement may cause a firm’s management to avoid government assistance, and Dodd-Frank repeals statutory authorization for direct assistance to failing firms outside the OLA.

Unfortunately, Dodd-Frank’s approach to ending public bailouts does not hold up. The Federal Reserve might still be able to invoke already-existing avenues for public bailouts by facilitating mergers and sales on favorable terms, as happened during the last financial crisis.

More fundamentally, public bailouts won’t disappear with the waving of a magic legislative wand. Congress can still authorize future public bailouts, and will do so again until the political and financial elite believe that large institutions can fail without destroying our economy.

If the FDIC can be expected to implement the OLA and its liquidation requirement properly, the OLA could reduce moral hazard for some players. However, indications are that the FDIC won’t adhere to even the spirit of a “liquidation” authority.

The OLA plans for a “single point of entry” approach, which will almost certainly increase moral hazard for the subsidiaries of financial institutions. The FDIC will liquidate the institution’s parent holding company and create a bridge financial company for the remaining assets, including the company’s preserved and recapitalized critical subsidiaries. Preserving those subsidiaries will likely prevent them from experiencing any loss at all.

The Financial Stability Oversight Council does no better than the OLA at ending TBTF.

As the Competitive Enterprise Institute points out in its constitutional challenge to Dodd-Frank, Title I of the law gives the FSOC broadly defined powers to designate certain financial companies as systemically important financial institutions (SIFIs) and subject them to a tighter regulatory regime, the idea being that this reduces the likelihood that these companies will fail and demand government support.

Beyond that, the FSOC’s foundational premise — that heightened regulatory scrutiny can control systemic risk — is fundamentally flawed. Dan Balz has argued that President Obama’s weakness is for “the belief that if you could get enough smart people in a room, they could figure out a solution to whatever the problem was.” Here, his delusion  is that bureaucrats can design rules to regulate TBTF out of existence.

In reality, regulators inevitably favor large banks, and regulators lack the cognitive ability to remove risk from our financial system, which former Federal Reserve chairman Alan Greenspan attests to.

Thankfully, conservatives have alternative solutions that could begin to convince our nation’s financial and political elite that TBTF no longer exists.

Some have called for the breakup of the large financial institutions. But they’re not uniformly negative for our economy; they aren’t all ticking time bombs, bound to fail and impose costs on hardworking Americans. They do the best job of servicing larger, global corporations such as Walmart and facilitate expanded access to capital markets and other valuable services that smaller institutions cannot provide.

In a world where the choice was between breaking up Wall Street titans and maintaining TBTF, the costs of the former might make sense. But those aren’t our only choices. Here’s a non-exhaustive sampling of some of those alternative measures.

Capital requirements. Robust capital requirements — which dictate how much equity a firm must hold relative to its assets (the loans it extends and investments it makes) –– are essential to any Dodd-Frank alternative. Higher capital requirements give firms more cushion during a downturn, reducing TBTF by making individual failure less likely and helping other banks withstand the shock when some do fail. 

Stress-testing can also provide guidance for setting capital levels by demonstrating what ratios of equity to assets would ensure our economy’s resiliency during an economic downturn. These tests measure the soundness of SIFIs during a hypothetical devastating recession, which forces the largest firms to improve their ability to measure risk.

Despite their limited success, these tests must go further to help end TBTF, by measuring the systemic impact of an SIFI’s failure — how it would impact other related companies. Successful systemic stress tests could help convince market observers that a firm could fail without destroying our overall economy and could provide policymakers with guidance for how high to set capital requirements.

There certainly are potential drawbacks to a robust capital regime. As CNBC’s John Carney has pointed out, robust capital requirements that financial institutions are required by regulation to maintain could backfire. High levels are hard to keep up during a financial crisis, and creditors would be fearful of the regulatory seizure of non-compliant institutions. Robust capital requirements could also hurt economic growth by contracting credit. Capital requirements could be tied to the business cycle, however, and better-capitalized banks help the economy weather crises and recessions.

Contingent capital. Regulators should consider, as an alternative or complementary measure, imposing contingent capital requirements on larger firms. As professors Iman Anabtawi and Steven Schwarcz explain, this form of debt “would automatically convert to equity [basically stock] upon the occurrence of pre-agreed events, such as a specified deterioration of a firm’s financial condition.”

This would help our financial system in at least three ways. First, firms would have an incentive (to avoid dilution of their equity) to proactively restore capital levels during an economic downturn; equity levels declined during the run-up to the last crisis, and halting this decline earlier could have reduced the severity of the downturn. Second, it would encourage existing shareholders and management to police excessive risk-taking and provide another line of defense against a costly conversion. Finally, it would force firms system-wide to build into their capital structure an ability to manage losses, rather than leave the federal government to serve as the backstop.

A new chapter of the bankruptcy code. The Hoover Institution is developing a proposal for a new “systemic” chapter of the bankruptcy code (Chapter 14) for resolving financial institutions with more than $100 billion in assets. This would offer a more predictable, rules-based approach to resolving larger financial institutions while still considering the concerns that led the federal government to circumvent the normal code with institutions during the last crisis. (It would also end the OLC.)

Targeted suspensions of mark-to-market accounting. Losses in 2008 accumulated so quickly in part because of mark-to-market accounting, which requires companies to value their financial assets based on their present market value, even if a market is non-functioning. When mortgage-related asset prices dropped precipitously during the financial crisis, banks had to raise expensive capital or frantically sell otherwise valuable assets to meet regulatory requirements. Asset prices went into a downward spiral, which only forced banks to panic more. Policymakers could consider a system that suspended mark-to-market accounting according to a market-based trigger.

Taxing TBTF. If after all of this some financial institutions still receive an unfair advantage from a perception of TBTF, policymakers could take up the plan of Boston University professor Con Hurley to require big firms to “set aside reserves equal to the net advantage — funding and otherwise — they get for being big,” as determined by the Federal Reserve. These reserves could be accessed only to cover obligations if a firm downsized. This policy would exert market pressure on firms to downsize, without forcing them to do so.

Of course, even with effective hedges against TBTF, a financial system would still require some prudential regulations (ideally, ones that are simple and easy to enforce). While the path of least resistance on this complicated topic may be to embrace populist calls to break up Wall Street, these policy alternatives hold more promise and should be thoroughly considered before conservatives seek to offer their own answers to the problems that the financial crisis of 2008 exposed and exacerbated.

— Ammon Simon is a policy counsel at the Judicial Crisis Network.

 

Did you like this?