The Dallas Fed Proposes Break-up of Megabanks
FRIDAY JANUARY 25, 2013
A report released by the Dallas branch of the Federal Reserve Bank last Thursday is calling for a re-thinking of efforts to prevent a future financial crisis. The report outlines the Dallas Fed’s position on how regulators should address megabanks that are deemed to be “too-big-to-fail” – or TBTF. Both the Director of Research and the Executive Director of the Dallas Federal Reserve, Harvey Rosenblum and Richard Fisher, have proposed breaking up the nation’s largest banks and withdrawing Federal support from all non-commercial banking operations.
In a speech to the Committee for the Republic in Washington D.C. on Wednesday, Fisher outlined the branch’s key recommendation: “In a nutshell, we recommend that TBTF financial institutions be restructured into multiple business entities. Only the resulting downsized commercial banking operations – and not shadow banking affiliates or the parent company – would benefit from the safety net of federal deposit insurance and access to the Federal Reserve’s discount window.”
The recommendation is designed to solve the TBTF problem in a more simplistic way, as the process of financial reform in the United States has come under fire for spawning too much complexity. As The Economist reported last year, financial reform may be “too big not to fail.” The Fed report comes at a time when the debate over many of the final rules of the Dodd-Frank Wall Street Reform and Consumer Protection Act is intensifying. The act was passed in the wake of the 2008 crisis to ameliorate some of the more egregious abuses of the U.S. financial sector, but final rules are still being written by the regulatory authorities tasked with implementing the bill.
In spite of thousands of pages of new rules, ‘too big to fail’ has not been solved
The law-making process has been ongoing since passage of the bill in July of 2010. The 848 page financial reform bill has already spawned thousands of additional pages of final rules, but only 136 of the 398 total required rulemakings have been written. As industry stakeholders and others have battled over the final shape of the reforms, 142 of 237 deadlines have been missed by regulators.
In his speech, Fisher states, “We contend that Dodd-Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better.” According to him, that is because smaller community banks “are being victimized by excessive regulation that stems from responses to the sins of their behemoth counterparts.” Addressing “too-big-to-fail” is one of two main points from the report; the second is that relative to larger banks, small community banks were much more resilient in the face of financial crisis.
The TBTF problem is widely viewed as the fundamental one to be addressed by Wall Street Reform. Fisher noted in his speech that the problem has gotten worse since the crisis, with financial assets becoming more concentrated in the hands of megabanks. According to the most recent data, just 12 institutions or .2% of U.S. banks hold 69% of industry assets. By contrast, 98.6% of all U.S. banks, the smaller ones, hold only 12% of assets.
Solving “too-big-to-fail” is a fundamental goal of Dodd-Frank and it is written into the preamble of the act, along with the assertion that taxpayers should never again have to bail out a private financial institution. The decision to let Lehman Brothers fail in 2008 was also made to prevent future moral hazard problems that arise from TBTF status. Testifying before Congress in September 2010, Chairman of the Federal Reserve Ben Bernanke said, “If the crisis has a single lesson, it is that the too big to fail problem must be solved.”
A report by the Peterson Institute for International Economics published in 2010 sums up the TBTF problem. Its authors explain that some financial institutions are so large, so interconnected, and so complex that their failure can cause widespread damage to the financial system. At the time of the report, the six largest bank holding companies in the United States had combined assets of $9.5 trillion, or roughly 13% of total global economic output.4 As a result, policymakers are unwilling to let them fail, because the consequences would be disastrous, as the failure of Lehman Brothers in 2008 has driven home. According to the Peterson Institute paper, when TBTF institutions, officially known as systemically important financial institutions (SIFIs) fail, policymakers are “faced with the unpalatable binary choice between massive bailouts and market chaos.”
This leads to a situation where banks are not disciplined by shareholders or the market into taking appropriate risks; in fact, the argument goes, they are encouraged to take larger risks because the potential upside is huge while downsides are covered by implicit federal guarantees. In other words, if they gamble and lose they won’t have to pick up the tab. The perverse incentive is known to economists as a “moral hazard” problem and to U.S. investment bankers as the “Greenspan Put.” In financial parlance, a “put” is an options contract that hedges against downside risks. The term “Greenspan Put” refers to the tendency of the Federal Reserve to provide emergency funding to bail-out investment bankers if a substantial portion of their portfolio turns sour. The term originated with the bail-out of Long Term Capital Management in 1998.
A solution may lie in simplicity
The TBTF problem, according to the Peterson Institute paper, is three-fold. First, banks have reduced incentives to prudently manage risk and due to their size, they represent a potentially massive contingent liability for governments as private losses are turned into public debt; second, the implicit federal guarantee gives them a preferential credit rating and access to cheaper finance, which distorts competition and causes them to outgrow smaller banks, making the problem worse; third, preferential treatment for large banks in the aftermath of a crisis “lowers public trust in the fairness of the system.” Both the Dallas Federal Reserve proposal and a large part of international financial regulatory reform is designed to tackle the problem, but in different ways.
Internationally, regulatory proposals have followed the recommendations of a 2009 report by the Financial Stability Board entitled “Reducing Moral Hazard.” First, the new Basel capital adequacy standards, known as Basel III, include an additional 2.5% capital requirement for banks that are deemed to be “systemically important.” 29 institutions have been identified globally by the Basel Committee and will face this “Pigouvian tax” -a surcharge designed to make up for costs that would otherwise be externalized by private firms. Second, the G-20 nations have made commitments to establish regulations that require large firms to construct what are known as “living wills” in order to establish “orderly resolution regimes.” These “living wills” are pre-planned bankruptcies designed to ensure that the failure of a large institution occurs in an “orderly” fashion. Rules requiring living wills at financial institutions are being implemented in the United States under Dodd-Frank. Finally, Dodd-Frank bans bail-outs outright under the expectation that financial institutions can be rescued through private “bail-ins” whereby uninsured creditors to the institution are forced to suffer losses or organize enough private financing to rescue the firm’s operations. This may involve breaking up parts of the institution during a crisis and placing those parts in federal receivership, under the Federal Depositor Insurance Corporation’s program of creating bridge banks.
But even though large infusions of taxpayer dollars into private financial firms, with little strings attached, violate the spirit of the Dodd-Frank Act, there is a general feeling that the provision is unenforceable. For example, reporter Michael Hirsch quoted “a senior Federal Reserve official” in a March, 2011 article for the National Journal as having said, “Citibank is a $1.8 trillion company, in 171 countries with 550 clearance and settlement systems . . . We think we’re going to effectively resolve that using Dodd-Frank? Good luck!” In congressional testimony, MIT economist Simon Johnson writes, “The [Federal Deposit Insurance Corporation] can close small and medium sized banks in an orderly manner, protecting depositors while imposing losses on shareholders and even senior creditors. But to imagine that it can do the same for a very big bank strains credulity.”
Some proponents of the new regulations believe that breaking up the megabanks, as the Dallas branch is advocating, is an unnecessary and even radical step. However, the Dallas branch is not alone in its assertion that these regulations are overly complex and potentially ineffective; prominent economists and regulators that have made similar arguments include Federal Reserve Governor Daniel K. Tarullo and Simon Johnson. In an article published by VOX last Thursday, the Executive Director on Financial Stability at the Bank of England, Andrew Haldane, also argues that in spite of the new reforms, regulators have not solved the TBTF problem. He says, “market expectations of state support for US banks are higher today than before the crisis struck and are unchanged since Dodd-Frank became law.”
Last month, Tarullo made arguments for legislation in addition to the Dodd-Frank Act in order to rein in megabanks at a debate on the issue held at the Brookings Institute. Tarullo recommended that large banks be forced to set aside more capital for a private fund to be used for future bail-outs. He also called for legislation that would limit the growth of large banks by placing limits on the amount of non-depositor funds that they can use for operations. There is so far no additional legislation being considered in Congress to implement the proposals, but there is growing pressure to do something more substantial about the issue. The Dallas Federal Reserve proposal represents an incipient movement towards a more simplistic, alternative approach to the issue.