William Dudley, President of the NY Fed Bank, framed the issue of TBTF in a speech last November:
The root cause of “too big to fail’ is the fact that in our financial system as it exists today, the failure of large complex financial firms generate large, undesirable externalities. These include disruption of the stability of the financial system and its ability to provide credit and other essential financial services to households and businesses. When this happens, not only is the financial sector disrupted, but its troubles cascade over into the real economy. There are negative externalities associated with the failure of any financial firm, but these are disproportionately high in the case of large, complex and interconnected firms.
So essentially, Dudley says that large and complex banks are problematic because their failure poses a huge structural risk. Think about it this way: if a normal-size bank fails, it disrupts a small shar e of the market because certain customers can no longer exchange credit. If a larger bank fails, it disrupts more customers. But the real problem with today’s banks is the level of complexity. Every institution is tied to a hundred others, which means that the failure of a single, well-connected firm throws off all the others.
Which is what happened in 2007. So after Bear Stearns and Lehman failed, the government decided that it wanted to contain the damage and ensure macroeconomic stability. So other big financial names, with ties that spread across the global economy—AIG, Wells Fargo, and CitiGroup—got bailout money.
The problem is that TBTF makes taxpayers responsible for future financial crises by increasing the likelihood of a bank failing: if the government agrees to support any firm that makes the wrong decision, bankers are incentivized to make risky decisions and go for the big yield. Furthermore, if the government creates a safety net to catch any big bank that fails, markets price the banks’ risk too low and subsidize borrowing costs via lower interest rates (which is what Warren was getting at). Thus, banks see size and complexity as good for business and are incentivized to get bigger and more complex.
To address the problem, it is important to ensure that governments don’t have to bail out the failed banks. Such a move would alter market expectations and disincentivize increases in size and complexity.
Reform efforts have looked to address an additional two essential questions. First, how do we reduce the rate at which firms fail? Second, how do we reduce the damaging effects of banks if they do fail?
The first question is best answered by examining what happened in 2007.
Obviously, the collapse of the housing bubble initiated the crisis. But a decline in housing prices alone wasn’t enough to send banks spiraling downwards. It was the fact that banks couldn’t find enough cash to cover their losses. In a desire to reach for higher yields, firms became too leveraged with risky investments, and didn’t have enough equity to cover their rapidly depreciating assets and debt. Here is a graph from the Fed Bank of Boston that illustrates the leverage ratio (debt to equity ratio) of five major banks leading up to the collapse in Fall 2007:
Source: Fed Bank of Boston
As a result, government regulators have moved to set up more strict capital requirements to ensure that banks have enough cash on hand to cover future investments. These new regulations have come via Basel III, a set of global banking standards passed in 2011 that are scheduled to be phased in starting this year.
We’ll have to wait and see the effects of Basel on firms’ behavior, but other reforms meant to reduce the likelihood of firms failing have already been enacted. These reforms, which include more oversight of derivatives trading and regulator-led stress testing, seem to have reduced the leverage on banks’ balance sheets— according to the Fed Bank of St. Louis, the capital ratio of all US banks (not just big banks) has reached its highest level in 25 years:
Source: Kohlberg Kravis Roberts
However, very little can really be done to eliminate the chance of a firm failing, and it is a realistic threat that every company faces in economic crises. Despite the fact that regulations have ensured that the firms don’t make the same explicit mistakes as in 2007 (tying themselves up in derivatives and leveraging themselves with debt), banks are surprisingly good at finding new ways to make bad decisions. So the more realistic approach to avoid a repeat of 2007 is to address ways to to reduce the systematic impact of a firm’s failure.
The most popular approach (favored by Elizabeth Warren) to reduce the economy-wide risk posed by TBTF has been to encourage smaller financial institutions. However, the argument against this approach is that that is that massive, global institutions provide a significant economy of scale for exchanging capital in increasingly massive and global markets. Indeed, this is true, but the decreasing average cost of financial transactions is supported the lenient precedent government policy has set of coddling big banks and rewarding risk (discussed above).
The real disagreement, then, is how to go about reducing the cost of bank failure. To date, the Fed has taken a relatively hands-off approach. Instead of directly breaking up the banks, their reforms have tried to shape market expectations and set new incentives for banks. Look at Bernanke’s response to Warren’s questioning on TBTF:
I would make another prediction, and prediction is always dangerous, that the benefits of being large are going to be small…are going to decline over time, which means that some banks are going to voluntarily begin to reduce their size because they are not getting the benefit they used to get.
Bernanke thinks that banks will “voluntarily” reduce their size because Dodd-Frank reverses the incentive to be bigger and more complex. The reform bill ties the Fed’s hands, as they are no longer allowed to bail out banks like they did in 2007. Instead, firms will be forced either through bankruptcy or “Orderly Liquidation Authority” (OLA), which will provide for the orderly break up of failed firms. OLA would seek to use the company’s equity to keep vital subsidiaries functioning, through wiping the value of every shareholder’s investment and using that money to keep the important parts of the bank functioning. The benefits of such an approach over a bankruptcy proceeding, according to Dudley, would be:
The greater speed at which a firm can be placed into a resolution process and stabilized, the ability to avoid disruptive creditor actions, and the availability of temporary backup liquidity support to continue critical operations.
So OLA allows quick action, continued flow of credit, and functionality in the parts of the bank most tied to other areas of the economy. Thus, failure of the banks can occur without disrupting the entire economy; the government won’t bail out larger firms, and incentives are created to shrink balance sheets.
It all sounds great to me. The only problem is that government policy hasn’t delivered all it has promised. See the next post for what should be done moving forward.
