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How to Fix Too Big to Fail
Dodd-Frank didn’t end it, but we still can.


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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.

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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.

 



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