FDIC Sheila Bair – “Too Big To Fail Creates Enormous Risk”

Too Big To Fail Doctrine Needs To Be Abandoned

FDIC Chairman Sheila Bair, in a speech at Georgetown University, outlined her plan for a better regulated financial system based on market discipline and ending the “too big to fail” concept.  Chairman Bair’s viewpoint is that the doctrine of “too big to fail” rewards mismanagement and excessive risk taking.

Chairman Bair’s call for reform of the regulatory system recognizes that significant regulatory gaps and lax supervision were responsible (in part) for our economic crisis.   In addition, it was sometimes difficult to distinguish between regulators and bankers.  Chairman Bair’s independence from Wall Street and the banking industry allows her to propose meaningful regulatory changes.

Chairman Bair had previously addressed the too big to fail issue by calling for the establishment of a Financial Company Resolution Fund (FCRF) to deal with the failure of systemically significant institutions.

Here are selected comments from the Chairman’s speech and I would recommend a full read of her speech.

Closing the gaps

It’s very clear that one of the causes of the economic crisis is significant regulatory gaps within the financial system. Differences in the regulation of capital, leverage, and consumer protection, and the almost complete lack of regulation of over-the-counter derivatives, allowed rampant regulatory arbitrage. Reforms are urgently needed to close these gaps.‪

At the same time, keep in mind that much of the risk in the system involved firms that were already subject to extensive financial regulation. One of the lessons of the past few years is that regulation alone is not enough to control imprudent risk-taking within our dynamic and complex financial system. You need robust and credible mechanisms to ensure that market players will actively monitor and keep a handle on risk-taking. In short, we need to enforce market discipline for systemically important institutions.

In a properly functioning market economy there will always be winners and losers. So when firms, through their own mismanagement and excessive risk-taking, are no longer viable, they ought to fail. Preventing companies from failing ultimately distorts market discipline, including the incentive to monitor competing firms and to allocate resources to the most efficient ones.‪

Unfortunately, measures taken during the past year – while necessary –have only reinforced the idea that some financial firms are simply too big to fail. Today, we now have fewer players in critical areas of our markets. The market is even more concentrated and interconnected than before. And unless we adopt needed reforms, our system will be more, not less, fragile after this crisis.

Vicious circle remains

This too-big-to-fail doctrine creates a vicious cycle that needs to be broken. Large firms can borrow more cheaply and on more favorable terms because the market assumes the government will not let them fail. Equity investors also have relied on an implicit government guarantee – with an unlimited upside, but a very limited downside. In effect, the largest firms socialized their risks and costs – by not paying for equity and credit based on their true risk – while keeping the enormous profits during good times.

This creates equally enormous risks for the system. Big firms leverage their operations to make still greater profits, while investors and creditors become more complacent and more likely to extend credit and funds without fear of losses.‪‪‪

For senior managers, the incentives are even more skewed. Paid in large part through stock options, senior managers have an even bigger economic stake in going for broke, because their upside is so much bigger than any possible loss. And, once again, with too big to fail, the government takes the downside risk.‪‪

Need for new resolution authority

To end too big to fail, we need an orderly and highly credible mechanism that’s akin to the process we use to resolve FDIC-insured banks. When the FDIC closes a bank, what typically happens is shareholders are wiped out … creditors take a substantial haircut, management is replaced, and the remaining assets of the failed institution are sold off.

‪The process is harsh. It’s painful. But it works. It quickly puts assets back into the private sector, and into the hands of better management. And it limits the cost of the takeover to the FDIC’s insurance fund. It also sends a strong message that investors and creditors face losses when an institution fails. So-called “open-bank” assistance for large complex firms should be prohibited. This assistance puts the interests of shareholders and creditors before that of the public.

If anything is to be learned from this crisis, it’s that market discipline must be more than a philosophy for warding off needed regulation in good times. It must be enforced during difficult times. We have an effective process to close banks – but we do not have such a process to close large holding companies or other large firms, like Lehman. We need an orderly process for winding down these large, systemically important financial firms without imposing costs on taxpayers.

Unlike what we have now, a new resolution regime would focus on maintaining a failed institution’s liquidity and key activities so it can be resolved without the near panic we saw a year ago. Losses would be borne by the stockholders and bondholders of a holding company, and senior managers would be replaced.

Systemic oversight council

We’re also in need of a regulatory framework that’s proactive, and identifies issues and trends that pose risks to the broader financial system. The new structure, featuring a strong oversight council, would monitor the financial system, from insurance companies to banks. By looking broadly across all of the financial sectors, the council will be able to adopt a “macro-prudential” approach.

Other gaps

Another huge gap that desperately needs plugging is the lack of regulation of over-the-counter derivatives, like the credit default swaps that crippled insurer AIG.

I support most of the Financial Accounting Standards Board’s changes to bring more assets on balance sheet, to limit the opportunities for hiding assets in special purpose entities, and to require more balanced accounting treatment. These favor transparency. Some proposals, however, do not appear to advance the ball.

In some cases, marking banking assets to market prices doesn’t make sense. When a bank is holding a deposit, a loan or a similar banking asset for the long-term, it shouldn’t have to mark them to market values that may vary widely over time. Extending MTM accounting to all banking assets takes a good approach for market-based assets, like securities, but extends it to areas where it doesn’t accurately reflect the business of banking.

We don’t need to deepen crises by inaccurately reporting so-called market values for loans and other banking assets. This introduces a level of pro-cyclicality that can have dire consequences when the accounting is divorced from reality. During good times, such an approach could inflate the true value of bank assets and capital strength. And during periods of market stress, losses could be exaggerated.