‘Too Big To Fail’ Delaying Recovery, Undermining Public Trust


Federal Reserve Bank of Dallas recently published an essay titled Choosing the Road to Prosperity: 
Why We Must End Too Big to Fail – Now”
written by its Executive
Vice President and Director of Research Harvey Rosenblum.  This is part two of a summary of that essay.  Part one can be found here: Is Fed Endorsing Ending to Too Big to Fail?

financial institutions started to fail and credit froze in 2008 the Federal
Reserve used the customary tools to get the economy moving again, first cutting
and keeping the federal funds rate – what banks charge one another for
overnight loans – close to zero.  This
usually makes short-term credit available at lower rates, driving borrowing by
consumers and businesses while pushing up the value of assets thus bolstering
business balance sheets and consumer wealth. 
Declining rates drive down the dollar making U.S. exports cheaper and
more attractive overseas as long as other countries don’t also drive down
rates.  Second, the Fed has injected
billions of dollars into the economy by purchasing long-maturity assets on a
massive scale, pushing long term rates down as well.  While this reduces the burden on borrowers it
punishes savers, especially those who depend on interest payments.

growth restarted in mid-2009 it has been tenuous and fragile and stock market gains
while large have been volatile.  Job
growth has been disappointing with only a third of the jobs lost to the
recession regained.

sluggish recovery has confounded monetary policy.  Much more modest Fed actions have produced
much stronger results in the past.  So
what’s different now?”  Part of the
answer is excesses that have not been wrung out of the system including falling
house prices that continue to drag down the housing market.  “The Too Big to Fail (TBTF) banks remain at
the epicenter of the foreclosure mess and the backlog of toxic assets standing
in the way of a housing revival.”

part of the answer is the monetary policy engine is not hitting on all
cylinders.  Low federal funds rates haven’t
delivered a large expansion of credit because if one part of the economy isn’t
functioning properly it degrades the performance of the rest.  Some contributions to recovery such as asset
value and wealth have been weaker than expected partly because burned investors
are demanding higher-than-ever compensation for risk.

also requires well capitalized financial institutions and the machinery of
monetary policy haven’t worked well because of TBTF.  Many of the biggest banks still have balance
sheets clogged with toxic assets while smaller banks are in much better shape
either because they didn’t make big bets on mortgage-backed securities, derivatives
and other risky investments or if they did they have already failed. 

capital into the system as the Fed did in 2008 was necessary but one downside
was a residue of distrust in the government and the banking system and an
erosion of faith in American capitalism
It showed ordinary workers and consumers a “perverse side of the system”
where they see that normal rules of markets don’t apply to the rich, powerful,
and well connected.  TBTF violated basic
tenants of a capitalistic system. 
Capitalism requires:

  • The freedom to
    succeed and the freedom to fail. Hard
    work and good decisions should be rewarded; more importantly, bad decisions
    should lead to failure.
  • Government to
    enforce the rule of law. This requires
    maintaining a level playing field. TBTF undermines equal treatment, reinforcing
    the perception of a system tilted in favor of the rich and powerful.
  • Accountability. The perception and reality is that virtually
    nobody has been punished for their roles in the financial crisis.

economy faces two challenges.  The short
term must focus on repairing the mechanisms so the impacts of monetary policy
will travel through the economy faster and with greater force.  In the long term the country must ensure that
taxpayers won’t be on the hook for another massive bailout.  Both challenges require dealing with the threat
posed by TBTF institutions.

government’s main response to the crisis was the Dodd-Frank Wall Street Reform
and Consumer Protection Act and its effectiveness will depend on its final rules.  The lack of regulatory certainty has already
undermined growth and is delaying repair of the lending and financial markets
parts of the monetary policy engine. 

can have the most impact with Dodd-Frank by requiring banks to hold more
capital, “tacking on additional requirements for the big banks that pose
systemic risk, hold the riskiest assets and venture into the more exotic realms
of the financial landscape.”  Capital
cushions should be tied to size, complexity, and business lines and give TBIF
institutions more skin the game and restore market discipline.  Small banks didn’t ignite the regulatory
crisis and shouldn’t face the same burdens as big banks that follow risky
business models.  TBTF banks’ sheer size
and their presumed guarantee of government help provided a significant edge –
perhaps at least a percentage point – in the cost of raising funds.  Making them hold more capital will level the
playing field among banks.

capital requirements will require the biggest banks to raise equity through
stock offerings or by retaining earnings through reduced dividends.  “Banks that clean up their balance sheets
will have a better chance at raising new funds while laggards will find it more
difficult and may further weaken and need to be broken up, their viable parts
sold off to competitors.  It is important
to redistribute these assets so as to enhance overall competition.”

the near-zero federal funds rate helped many banks’ capital rebuilding process
it could be argued that the zero interest rates are taxing savers to pay for
recapitalizing those who caused the problem in the first place.

the sluggish recovery is a cost of the long delay in setting new standards for
.  Given the urgent need to
restore growth and a healthy job market “the guiding principles for bank capital
regulation should be:  codify and
clarify, quickly.  There is no statutory mandate
to write hundreds of pages of regulations and hundreds more pages of commentary
and interpretation.  Millions of jobs
hang in the balance.”

part of its strategy to end TBTF, Dodd-Frank expanded the role of regulators
and added new ones, in effect shifting responsibility from the Fed to Treasury
and injecting politics into the mix.  The
current remedy for insolvent institutions, i.e. FDIC resolution, works well for
smaller banks but TBTF rescues over the last three decades have penalized
equity holders while protecting bond holders and bank managers.  Disciplining the management of big banks,
just as happens at smaller bank, would reassure a public angry with reckless
behavior necessitating government assistance.

question remains whether the new resolution procedures will work in the next
crisis.  Because big banks often follow
parallel practices, odds are that several will get into trouble at the same
time and this might overwhelm even the most far-reaching regulator scheme.  TBTF might become TMTF – too many to fail –
as happened in 2008.

second issue is credibility.  The
Implicit guarantee imputed to Fannie Mae and Freddie Mac became explicit for
them and for big banks when the federal government did indeed come to their
rescue.  Words on paper only matter when bankers
and their creditors actually believe that Dodd-Frank puts government out of the
bailout business although the new law has begun enforcing some market
discipline.   “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.”

survivors of 2008 have not changed; their corporate cultures remain based on
short -term incentives of fees and bonuses, they have the lawyers and money to resist
federal regulation and, their significant presence in dozens of states confers
enormous political clout.

Dallas Fed has advocated breaking up the nation’s largest banks into smaller
units but it won’t be easy.  There are
thorny issues about how to reduce the size of banks; the level of concentration
deemed save will be difficult to determine, and the big financial institutions
will dig in to challenge any breakups. 
But a financial system composed of enough banks to ensure competition in
funding businesses and households with none big enough to put the overall
economy in jeopardy will give the country a better chance of navigating through
future financial difficulties and this level playing field will restore faith in
market capitalism.

stated at the beginning, the problems that periodically roil the financial
system are the result of complacency arising from sustained good times, greed
and irresponsibility that run riot without market discipline, the exuberance
that overrules common sense, and the complicity of going along with the
crowd.  These are natural to humans and
we cannot eliminate them, merely be alert to them.  But concentration in the financial sector is
not natural but rather the result of artificial advantages including that some
banks are TBTF.  Human weakness will
cause market disruptions; big banks backed by government turn them into

Frank hopes to eliminate TBTF but the new law leaves the banks largely intact
and they remain a danger to the financial system.  “The road to prosperity requires
recapitalizing the financial system as quickly as possible.  The safer the individual banks, the safer the
financial system.  The ultimate
destination-an economy relatively free from financial crises-won’t be reached
until we have the fortitude to break up the giant banks.”

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