Will “Too Big To Fail” Banks Crash The Financial System?

Why The Biggest Banks Are Too Big To Fail

The “too big to fail bank” issue has been debated ever since the financial meltdown of 2008 brought many of the mega banks to the brink of financial collapse.  The government’s recent moves to strengthen its financial regulatory powers over financial institutions has brought to center stage the issues of whether bank size should be limited and exactly what mechanisms should be put into place to deal with the potential failure of a mega bank.

Although the FDIC currently insures deposits at 8,195  banks and savings associations, 8,175 of those institutions are almost irrelevant since the top 20 banks have 70% of the entire banking system’s assets.   Even more astonishing is the huge concentration of assets at the “Top Five Mega Banks”.   The most recent FDIC Depository Report as of June 30, 2009 shows a total of $13.3 trillion dollars in assets held by the 8,195 FDIC insured institutions.  The Top Five Mega Bank’s total assets of $8.29 trillion represent a staggering 62.3% of total banking industry assets.

The "Mega Banks", courtesy WSJ

The failure of any one of the Mega Banks would be a systemic threat to the overall financial system and cause widespread public panic.  The government would, therefore, be forced to take whatever steps were necessary to avoid the risk of a financial meltdown caused by the failure of a mega bank.  The largest banks have officially become “too big to fail” and everyone knows it.   Given the de facto “too big to fail” policy, how do regulators deal with this huge concentration of risk and the potential failure of a “too big to fail” institution?

Policy Solutions To The Risks Of  “Too Big To Fail”

FDIC Chairman Sheila Bair has addressed the too big to fail issue in depth as previously discussed - see Bair Says Banks Not Viable Should Fail and Bair Comments On Banks Too Big To Fail.

Sheila Bair’s comments: “Of primary importance is addressing too big to fail. Market participants should understand that large institutions can and will fail and that an effective resolution mechanism will be uniformly applied to institutions in a fair, transparent and consistent manner. It is also important that we maintain a focus on assuring strong capital requirements for banks and their holding companies.”

On July 23, 2009, Sheila Bair set forth guidelines to deal with the failure of a large financial institution.

In a properly functioning market economy there will be winners and losers, and when firms — through their own mismanagement and excessive risk taking – are no longer viable, they should fail. Actions that prevent firms from failing ultimately distort market mechanisms, including the market’s incentive to monitor the actions of similarly situated firms. Unfortunately, the actions taken during the past year have reinforced the idea that some financial organizations are too big to fail.

The notion of too big to fail creates a vicious circle that needs to be broken. Large firms are able to raise huge amounts of debt and equity and are given access to the credit markets at favorable terms without consideration of the firms’ risk profile. Investors and creditors believe their exposure is minimal since they also believe the government will not allow these firms to fail.

Given this, we need to develop a resolution regime that provides for the orderly wind-down of large, systemically important financial firms, without imposing large costs to the taxpayers.

Even if risk-management practices improve dramatically and we introduce effective macro-prudential supervision, the odds are that a large systemically significant firm will become troubled or fail at some time in the future. The current crisis has clearly demonstrated the need for a single resolution mechanism for financial firms that will preserve stability while imposing the losses on shareholders and creditors and replacing senior management to encourage market discipline.

Regulatory Malpractice?

Thomas Hoenig, the president of the Kansas City Federal Reserve Bank has also expressed criticisms and possible policy solutions to the current “to big to fail” policy.  Consider Fighting To Rein In Big Banks’ Power.

In June Hoenig stirred up controversy when he accused the federal government of “regulatory malpractice” by creating another regulatory regime without addressing “too big to fail.” He warned of an “oligarchy of interest that will fail to serve the best interests of business, the consumer and the U.S. economy.”

Hoenig has resumed his campaign in op-ed articles in major newspapers. His main point: Talk about the prudent supervision of banks is putting the cart before the horse; standing in the way of real reform is failure to find a means of systematically dealing with the too-big-to-fail policy.

The phrase describes the special status apparently conferred on America’s biggest banks, which have received billions in taxpayer bailouts and guarantees in the name of keeping the financial system working. The federal government through bailouts has placed them beyond the normal penalties for failure — receivership, bankruptcy and disgrace. These big banks also happen to be among the largest contributors to both political parties.

To Hoenig, they represent the new aristocracy of U.S. commerce. For months the Kansas City Fed chief has called for policymakers to create a plan to break up the most insolvent of these institutions, putting them first into receivership. “If we hesitate to make needed changes,” he says, “we will perpetuate an oligarchy of interest.”

The concentration of power among a few mega-banks troubles Hoenig. “I’ve seen banks close for making mistakes,” says Hoenig. “I’ve seen other banks too big for the regulators, being supported by the U.S. taxpayer. It’s harmful to the infrastructure, and sends the wrong message, that influence is what really matters. If we fail to address ‘too big to-fail,’ it will only get worse.”

In fact, argues Hoenig, the Fed has been behind the process of creating the giants that today tower over the financial industry. “Because of too-big-to-fail, the Fed has encouraged merging sick banks into larger ones, a process that tends to concentrate risk.”

Does the mere existence of mega banks create systemic financial risks?   Some would argue that with proper regulation and the imposition of very strong capital requirements, systemic risks  would be reduced by allowing mega banks, since it would be easier to regulate and conduct proper oversight of a small number of large banks.

What Role Should The Fed Play In Regulatory Reform?

There are many critics of the proposal to make the Federal Reserve the primary regulatory to assess systemic risk.  Consider The Fed Can’t Monitor Systemic Risk.

The problem is the Fed itself can create systemic risk. Many scholars, for example, have argued that by keeping interest rates too low for too long the Fed created the housing bubble that gave us the current mortgage meltdown, financial crisis and recession.

All of this means just one thing: If we are to have a mechanism to prevent systemic risk it should be independent of the Fed. That is probably one reason why creating a systemic-risk council made up of all of the federal government’s financial regulatory agencies, including the Fed, has the support of Senate Banking Committee Chairman Christ Dodd (D., Conn.) and others on the committee.

But piling yet more responsibilities on the Fed raises the question of whether we are serious about discovering incipient systemic risk. If we are, then an agency outside of the Fed should be tasked with that responsibility. Tasking the Fed with that responsibility would bury it among many other inconsistent roles and give the agency incentives to ignore warning signals that an independent body would be likely to spot.

“Too Big To Fail” Dilemma Needs Solution

The banking system is dominated by a small number of mega banks.   The inherent risks associated with such an extreme concentration of assets cannot be ignored by regulators.  The hard part will be arriving at and implementing a solution so that the financial meltdown of 2008 will not be repeated.

More on this topic from The Big Picture:

Make Big Banks Smaller