Too Big To Fail: How to End It?

Harvey Rosenblum has written "Choosing the Road to Prosperity: Why We Must End Too Big to Fail—Now," in the 2011 Annual Report of the Federal Reserve Bank of Dallas. He does a good job of explaining the "why," but--perhaps constrained by his position at the Fed--pretty much whiffs on the question of "how."



Rosenblum points out that "too big to fail" is now de facto national policy (footnotes and references to exhibits omitted):  "In short, the situation in 2008 removed any doubt that several of the largest U.S. banks were too big to fail. At that time, no agency compiled, let alone published, a list of TBTF institutions. Nor did any bank advertise itself to be TBTF. In fact, TBTF did not exist explicitly, in law or policy—and the term itself disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government
assistance. Most of the largest financial institutions did not fail in the strictest sense. However, bankruptcies, buyouts and bailouts facilitated by the government nonetheless constitute failure. The U.S. financial institutions that failed outright between 2008 and 2011 numbered more than 400—the most since the 1980s."

Moreover, enabling banks with an overdose of toxic assets to stagger forward makes it hard for monetary policy to then use those banks as part of a mechanism for stimulating lending and the macroeconomy: " Bank capital is an issue of regulatory policy, not monetary policy. But monetary policy cannot be effective when a major portion of the banking system is undercapitalized. The machinery of monetary policy hasn’t worked well in the current recovery. The primary reason: TBTF financial institutions. Many of the biggest banks have sputtered, their balance sheets still clogged with
toxic assets accumulated in the boom years."

So far, the policy response to "too big to fail" has taken two forms: promising not to do it again, and higher capital requirements. Neither is likely to put an end to "too big to fail." 

The Dodd-Frank legislation promises no more bank bailouts--but why would anyone believe such a vow? 

"Dodd–Frank says explicitly that American taxpayers won’t again ride to the rescue of troubled financial institutions. ... Going into the financial crisis, markets assumed there was government backing for Fannie Mae and Freddie Mac bonds despite a lack of explicit guarantees. When push came to shove, Washington rode to the rescue. Similarly, no specific mandate existed for the extraordinary governmental assistance provided to Bear Stearns, AIG, Citigroup and Bank of America in the midst of the financial crisis. Lehman Brothers didn’t get government help, but many of the big institutions exposed to Lehman did. Words on paper only go so far. ...


"While decrying TBTF, Dodd–Frank lays out conditions for sidestepping the law’s proscriptions on aiding financial institutions. In the future, the ultimate decision won’t rest with the Fed but with the Treasury secretary and, therefore, the president. The shift puts an increasingly political cast on whether to rescue a systemically important financial institution ...The credibility of Dodd–Frank’s disavowal of TBTF will remain in question until a big financial institution actually fails and the wreckage is quickly removed so the economy doesn’t slow to a halt. Nothing would do more to change the risky behavior of the industry and its creditors. For all its bluster, Dodd–Frank leaves TBTF entrenched."

Higher capital requirements will reduce some of the advantage of giant banks: "Policymakers can make their most immediate impact by requiring banks to hold additional capital, providing added protection against bad loans and investments. ... TBTF banks’ sheer size and their presumed guarantee of government help in time of crisis have provided a significant edge—perhaps a percentage point or more—in the cost of raising funds. Making these institutions hold added capital will level the playing field for all banks, large and small."

But higher capital requirements are mainly aimed at reducing the need for bank bailouts, one bank at a time. In a systemic financial crisis, they may well not suffice: "A nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme. In all likelihood, TBTF could again become TMTF—too many to fail, as happened in 2008."

It seems to me that if one is deeply serious about stopping too big to fail, two other policies need to be considered. One possibility would be a policy of "narrow banking," where banks are perhaps limited to commercial banking, investment banking, and wealth management, but are barred from running hedge funds, or being dealers or market makers in financial securities.  I posted about one such proposal along these lines a couple of weeks ago, in "What Should Banks Be Allowed To Do?"  Such "narrow" banks would take on less risk, and would also be limited to operating in a smaller part of the overall market for financial services

The other possibility is to put a limit on how big banks can grow. Rosenblum writes in a footnote: "Evidence of economies of scale (that is, reduced average costs associated with increased size) in banking suggests that there are, at best, limited cost reductions beyond the $100 billion asset size threshold. Cost reductions beyond this size cutoff may be more attributable to TBTF subsidies enjoyed by the largest banks, especially after the government interventions and bailouts of 2008 and 2009."

Rather than letting TBTF provide an implicit subsidy for greater size, the government could require that when a bank grows to, say, $200 billion in assets, it needs to develop a plan for splitting itself in two, and when a bank approaches $300 billion in assets, it needs to put that plan into effect. For banks, an advantage of such a proposal is that their activities would not need to be restricted, because the failure of even a few such banks wouldn't be catastrophic. For perspective, JPMorgan Chase and BankAmerica both had more than $2 trillion in assets in 2011, while Citigroup and Wells Fargo both had well over $1 trillion in assets. Too big to fail, indeed.