Why Too-Big-to-Fail Shouldn't Be Codified

The new legislation unveiled by Representative Barney Frank doesn’t end “too big to fail” — it codifies it. It also puts taxpayers on the hook for a large portion of future bailouts.

Frank should go back to the drawing board. Per the recommendation of Bank of England Governor Mervyn King, he should split banks in half, sending trading operations off into the wilderness so banks can get back to basics.

The need for resolution authority stems from regulators’ arguments that they didn’t have the tools to shutter big firms last year. They knew losses properly belonged to shareholders and creditors. They just didn’t have the power to execute such a plan.

Color me skeptical.

Just as likely, they were terrified that shuttering a systemically important financial institution would cause financial markets to panic, that the daisy chain of derivative counterparties would break, collapsing the system.

If it’s so difficult to wind down large bank holding companies that it requires new, complex resolution authority, common sense tells us such institutions shouldn’t exist in the first place.

The goal should be to prevent banks from getting into danger, to get them out of risky activities that pose systemic risks. Bank regulators already have broad powers to do this, yet they’ve shown little willingness to use them.

Some argue they were stymied by regulatory shopping, so this legislation would give more power to the Fed. But will the Fed use it?

Last week, it installed as its top regulator Patrick Parkinson, long an advocate of a hands-off approach to derivatives: “Counterparties typically are quite adept at managing credit risks,” he testified in 1999. Whoops.

In any case, codifying institutions as too big to fail is likely to backfire by signaling to the market that such banks are the safest place for capital.

Advocates of this legislation say that won’t happen, that “Tier 1 Financial Holding Companies” will face capital and leverage requirements that put them at a disadvantage. But that’s not in this legislation; those new rules are to be written and enforced by regulators who have shown a remarkable lack of fortitude to date.

Advocates also say the legislation puts bank investors in line to absorb losses. But aren’t they already? The reason too-big-to-fail is a problem is that the capital structure is so big and complex that forcing losses onto investors causes a systemic event.

Naturally, then, taxpayers will front the money to fund a good chunk of these resolutions. Supposedly banks with more than $10 billion of assets will pay taxpayers back. If you believe that, I’ve got a bridge in Brooklyn.

Look how hard it has been to replenish the Deposit Insurance Fund. Banks threw a tantrum about a special assessment that raised all of $5.6 billion. Sheila Bair, the FDIC chairman, was forced to resort to accounting gimmickry to squeeze more cash out of them.

We could make banks tithe their profits for years and we would recover a fraction of the total cost of recent bailouts.

New resolution authority is nice to have, but it won’t resolve the problem. What we need to do is shrink and simplify banks so they don’t pose a systemic risk in the first place.

Mervyn King and Paul Volcker have both put ideas forward to do that. We’d be better served if Frank and his staff fleshed those out.

Comments

[john s. gordon:]

hat off to the author - i couldn't have said it better myself.
> jack

Oct 29 09:52 AM

[H.J. Huneycutt:]

Great article.

I haven't seen the details of this plan yet, but it does seem like the emerging consensus in investment circles is that it's toothless and might even do more harm than good. Which isn't much of a shocker to most of us familiar with the recent history of American politicians.

Oct 29 10:21 AM

[Stimpy:]

Well said, but the single biggest problem this legislation creates is that it contemplates visiting losses on creditors outside the normal BK proceedures.

Once you give the Gov't the ability to change Senior/Sub structures(like Chrysler) in banks they WILL STOP LENDING TO EACH OTHER AT 1/2% IN THE LIBOR MARKETS!

Oct 29 10:48 AM

[JohnAl:]

Some great points in this article.

Still another reason why institutionalizing "too big to fail" is a bad idea is because it will further legitimize political interference in these (and other?) institutions. In the long run, is that good for the economy?

And as the author points out, where's the proof that adding an additional layer of regulation will stop this from happening again? All it does is make someone (the regulators) accountable when it does happen again. Great. So there'll be somebody to blame and a head to lop off, but the taxpayers will still be on the hook, just as happened last year.

Back to the drawing board, Barney.

Oct 29 10:49 AM

[frosty:]

Glass-Steagall worked well for 60 years and look what

Oct 29 10:52 AM

[frosty:]

Glass-Steagall worked well for 60 years and look what happened after it was repealed. To big to fail legislation is also good as long as it's good legislation.


On Oct 29 10:52 AM frosty wrote:

> Glass-Steagall worked well for 60 years and look what

Oct 29 10:55 AM

[I am rage:]

Of course it doesn't change anything. They have things just the way they want them. This whole idea of breaking the banks up in the media is a dog and pony show, intended to appease a growing unrest about the idea of "too big to fail." They aren't going to do anything except make you THINK they did something productive. This is pretty much what the congressional finance and banking committees and the fed are good at.

Also, end the fed. That is all.

Oct 29 11:02 AM

[Tesa:]

Yes the brake up alone does not fix the problem. The easiest solution would be to have banks spawn their various operations into different symbols and isolate their operations. Different money streams with different risk profiles should not be used to subsidize each other in financial world.

The operational brake up is what is material and not the size. The financial companies should be able to spawn their various operations easily and that will actually create more transparency as sell.

And not just banks, financial arm of an Engineering company or auto company should be listed in the markets with a different symbol for example and be insulated. And yet big companies can grow bigger with this style of growth by adding growth of same components with similar risks with less of ability to hide risk under their carpets.

Oct 29 11:19 AM

[GeminiAtlas:]

I'd say either add a chapter to bankruptcy or to the anti-trust. If they are too big to fail, it means they are too big, period. Accordingly they would need to be charged a risk premium to be "too big to fail" as right now they are free-riding the risk to the taxpayers. Thus, either A: use anti-trust to break up the company a la Ma-Bell into smaller companies and see which ones fail and which ones succeed thereafter. Or B: Since the congress is so keen on "progressive" tax schemes, then maybe it will be progressive in leverage ratios. in that regard, the risk premium to be paid would be in reigned in lending ratios. Basically, the bigger you are as a bank, the more conservative the lending ratio you are allowed. So the huge mega-banks are required to be 10-to-1 or something like that, and the smaller regional banks can be allowed a higher ratio, since if they fail, it is not systemically risky as if Citi were to founder. Of course, one might suppose that the big banks might try to make riskier loans to make more money under such a regime. But that would happen anyways, much better bad loans at 10:1 then 30:1.

Oct 29 11:25 AM

[Big Bubbette:]

Re-instate the Glass-Steagall Act, but break the too big too fail back into their component parts. Savings banks doing mortgages with underwriting standards (hello), and investment banks that want to take risks and can be shown the door to the bankruptcy court. While the repeal of the Glass-Steagall Act was a part of the problem there was a concerted effort to deregulate the banks and investments to allow these monsters bubble machines to grow. Even with the proposed regulations it is not clear these issues will be dealt with.

Go back to 1999 when Clinton and a group of Republicans repealed the Glass-Steagall Act:
The Gramm-Leach-Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999, (Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999) is an act of the 106th United States Congress (1999-2001) which repealed part of the Glass-Steagall Act of 1933, opening up the market among banking companies, securities companies and insurance companies. The Glass-Steagall Act prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and/or an insurance company.

The Gramm-Leach-Bliley Act allowed commercial banks, investment banks, securities firms and insurance companies to consolidate. For example, Citicorp (a commercial bank holding company) merged with Travelers Group (an insurance company) in 1998 to form the conglomerate Citigroup, a corporation combining banking, securities and insurance services under a house of brands that included Citibank, Smith Barney, Primerica and Travelers. This combination, announced in 1993 and finalized in 1994, would have violated the Glass-Steagall Act and the Bank Holding Company Act of 1956 by combining securities, insurance, and banking, if not for a temporary waiver process.[1] The law was passed to legalize these mergers on a permanent basis. Historically, the combined industry has been known as the "financial services industry".

en.wikipedia.org/wiki/...

Reinstatement of parts of the Glass-Steagall Act and other regulations need to be put in place. We do not need more government bureaucracy to intrude in business. Break up the too big too fail and send the parts with the massive debt to the bankruptcy court, as it should have been in the first place and not move the debt to the taxpayer.

It is estimated that currently 95% of all mortgages are being issued by the government guaranteed by the taxpayer under Freddie, Fannie and Ginnie. That needs to change.

Oct 29 11:55 AM

[bob adamson:]

Given last year’s meltdown, it’s a bit too late to argue convincingly that the free market and the normal bankruptcy laws alone should have free reign to deal with any problems that might arise in the future in the investment banking industry. The task therefore is to devise a balanced scheme that doesn’t over shoot the mark in reaction to the current lack of an adequate scheme. For argument’s sake, here is a list of the characteristics a TBTF resolution scheme should exhibit:
1. It should cover banks and near banks that engage in investment banking.
2. It should define what characteristics a financial institution must have before it is covered by the scheme (i.e. which banks and near banks are of sufficient size and are engages in appropriate business activities to be monitored for the need to have intervention under the scheme if they should become ‘troubled’).
3. The oversight agency and its capacity to monitor and intervene need to be defined.
4. An expedited summary procedure to allow the oversight agency to intervene and re-organize or wind-up a troubled monitored company should be detailed, including an expedited appeal process.
5. The oversight agency should have its operating costs covered by a levy against the investment banking participant companies generally (both those monitored and those not then subject to monitoring by the agency) to ensure that it is both properly resourced and remains independent.
6. During the start-up phase of the scheme the oversight agency should have the capacity to recover, by retroactive special levy against the companies that normally cover the agency’s operating costs, the costs of the wind-up or re-org of a failed investment bank or near bank it monitors. For the longer term, these companies should be required to pay into an insurance pool so that money is available as needed to cover these recovery costs. As residual capacity to impose a special levy should continue in case the insurance pool is insufficient in some contingency.

The key is to define the framework and basics but not try to micro-manage legislatively in advance by including too many details of management and administration in the legislation.

It would be great if a new Glass-Steagall Act were also enacted and the industry reorganized to meet its terms.

Any thoughts or reactions?

Oct 29 01:47 PM

[Alan Young:]

"Frank should go back to the drawing board.... he should split banks in half,"
Hah! If Barney Frank had the power to split up banks, he would have done it long ago. But even the Pope can't do that. So this is nonsense. Frank is trying to find a solution that's politically achievable. It won't be ideal, because the criminals still have a huge amount of influence in Washington.

So, talk all you want about what would be ideal. Meanwhile, how do we *really* prevent another meltdown, without throwing another $700 billion of future-taxpayer money at it?

Oct 29 02:44 PM

[bob adamson:]

My earlier post should have more explicitly stated that the new scheme needs to improve the ongoing reporting requirement to the public and equity holders as well as to the new monitoring agency that all banks and near banks engaged in significant investment banking would have to implement.


On Oct 29 01:47 PM bob adamson wrote:

> Given last year’s meltdown, it’s a bit too late to argue convincingly
> that the free market and the normal bankruptcy laws alone should
> have free reign to deal with any problems that might arise in the
> future in the investment banking industry. The task therefore is
> to devise a balanced scheme that doesn’t over shoot the mark in reaction
> to the current lack of an adequate scheme. For argument’s sake, here
> is a list of the characteristics a TBTF resolution scheme should
> exhibit:
> 1. It should cover banks and near banks that engage in investment
> banking.
> 2. It should define what characteristics a financial institution
> must have before it is covered by the scheme (i.e. which banks and
> near banks are of sufficient size and are engages in appropriate
> business activities to be monitored for the need to have intervention
> under the scheme if they should become ‘troubled’).
> 3. The oversight agency and its capacity to monitor and intervene
> need to be defined.
> 4. An expedited summary procedure to allow the oversight agency to
> intervene and re-organize or wind-up a troubled monitored company
> should be detailed, including an expedited appeal process.
> 5. The oversight agency should have its operating costs covered by
> a levy against the investment banking participant companies generally
> (both those monitored and those not then subject to monitoring by
> the agency) to ensure that it is both properly resourced and remains
> independent.
> 6. During the start-up phase of the scheme the oversight agency should
> have the capacity to recover, by retroactive special levy against
> the companies that normally cover the agency’s operating costs, the
> costs of the wind-up or re-org of a failed investment bank or near
> bank it monitors. For the longer term, these companies should be
> required to pay into an insurance pool so that money is available
> as needed to cover these recovery costs. As residual capacity to
> impose a special levy should continue in case the insurance pool
> is insufficient in some contingency.
>
> The key is to define the framework and basics but not try to micro-manage
> legislatively in advance by including too many details of management
> and administration in the legislation.
>
> It would be great if a new Glass-Steagall Act were also enacted and
> the industry reorganized to meet its terms.
>
> Any thoughts or reactions?

Oct 29 03:02 PM

[Washington:]

Great article, Rolfe. I quote you here: www.washingtonsblog.co...

Oct 29 05:52 PM

[Mike Kane:]

what's next, too small to succeed? This too big to fail talk is nonsense.

Oct 30 11:03 AM

[jeffgroove:]

what's next, too small to succeed? This too big to fail talk is nonsense.

I couldn't agree more. How can these politicians regulate a system that gives them the most campaign money anyway, that is what has me scratching my head. Your article, while good in jest, do you really think they are going to bite the hand that feeds em? I have never really understood the political "rah!, rah!" of others, when a momentary lapse of reason and an old peice of junk computer with an internet connection can pretty much tell you what these rats are up to. I don't mean to rant too much here, but maybe generations of people in the future will look back on this time and wonder just exactly what pile of horse dung people were smoking. Or maybe this is just another case of entropy in action or things going from worse to worser. They should just call us, "America, for and by special interest". I think murray rothbard said it best, whenever a politician speaks, you should always ask "To who or whom's benefit?" Seriously though, our political system is such a joke, it is the equivalent of WWE monday night raw, and frankly these people should be laughed out of existence so they can crawl back under their rock from where they came.

Oct 30 02:26 PM

[untrusting ...:]

The answers are relatively simple and exist already:
1) Antitrust laws - no bank should be allowed to control more than say 10% of the US market. There are thousands of US banks already, so 10% is plenty big enough. They just need to enforce the antitrust laws and force the breakup over a reasonable time period. Should be easily accomplished by IPO's and bring in new investors. Plenty of the shadow banking system wants into banking, so let them and other investors in.
2) Glass-Stegall - reinstate it - should be no big deal to simply revoke the previous repeal of it.

The real issue is not that something can't be done. The real issue is the corruption and interconnectedness and vested interests between the politicans, lobyists, big bankers, and public companies. It is one hugh gravy train for the politicans and the big money and they will fight to the death to prevent any changes.


On Oct 29 02:44 PM Alan Young wrote:

> "Frank should go back to the drawing board.... he should split banks
> in half,"
> Hah! If Barney Frank had the power to split up banks, he would have
> done it long ago. But even the Pope can't do that. So this is nonsense.
> Frank is trying to find a solution that's politically achievable.
> It won't be ideal, because the criminals still have a huge amount
> of influence in Washington.
>
> So, talk all you want about what would be ideal. Meanwhile, how do
> we *really* prevent another meltdown, without throwing another $700
> billion of future-taxpayer money at it?

Oct 31 02:27 AM

[JMBishop:]

Easy, let the next melt-down happen, let the too-big-to-fail...fail, let the you-know-what hit the fan! "Freedom [is] just another word for nothing left to lose."

On Oct 29 02:44 PM Alan Young wrote:

> "Frank should go back to the drawing board.... he should split banks
> in half,"
> Hah! If Barney Frank had the power to split up banks, he would have
> done it long ago. But even the Pope can't do that. So this is nonsense.
> Frank is trying to find a solution that's politically achievable.
> It won't be ideal, because the criminals still have a huge amount
> of influence in Washington.
>
> So, talk all you want about what would be ideal. Meanwhile, how do
> we *really* prevent another meltdown, without throwing another $700
> billion of future-taxpayer money at it?

Nov 01 10:43 AM

[JMBishop:]

Would these actions protect bankers that take their fiduciary responsibilities seriously while allowing those bankers who want to run their operations like a casino suffer or enjoy the consequences of their own risk taking? In other words would "good" banks be safe when a "bad" bank failed...no matter what its size?

On Oct 29 01:47 PM bob adamson wrote:

> Given last year’s meltdown, it’s a bit too late to argue convincingly
> that the free market and the normal bankruptcy laws alone should
> have free reign to deal with any problems that might arise in the
> future in the investment banking industry. The task therefore is
> to devise a balanced scheme that doesn’t over shoot the mark in reaction
> to the current lack of an adequate scheme. For argument’s sake, here
> is a list of the characteristics a TBTF resolution scheme should
> exhibit:
> 1. It should cover banks and near banks that engage in investment
> banking.
> 2. It should define what characteristics a financial institution
> must have before it is covered by the scheme (i.e. which banks and
> near banks are of sufficient size and are engages in appropriate
> business activities to be monitored for the need to have intervention
> under the scheme if they should become ‘troubled’).
> 3. The oversight agency and its capacity to monitor and intervene
> need to be defined.
> 4. An expedited summary procedure to allow the oversight agency to
> intervene and re-organize or wind-up a troubled monitored company
> should be detailed, including an expedited appeal process.
> 5. The oversight agency should have its operating costs covered by
> a levy against the investment banking participant companies generally
> (both those monitored and those not then subject to monitoring by
> the agency) to ensure that it is both properly resourced and remains
> independent.
> 6. During the start-up phase of the scheme the oversight agency should
> have the capacity to recover, by retroactive special levy against
> the companies that normally cover the agency’s operating costs, the
> costs of the wind-up or re-org of a failed investment bank or near
> bank it monitors. For the longer term, these companies should be
> required to pay into an insurance pool so that money is available
> as needed to cover these recovery costs. As residual capacity to
> impose a special levy should continue in case the insurance pool
> is insufficient in some contingency.
>
> The key is to define the framework and basics but not try to micro-manage
> legislatively in advance by including too many details of management
> and administration in the legislation.
>
> It would be great if a new Glass-Steagall Act were also enacted and
> the industry reorganized to meet its terms.
>
> Any thoughts or reactions?

Nov 01 10:54 AM

[Gary A:]

As long as taxpayers are in the back of the line, behind stock holders, bond holders, creditors, banks and snake oil salesmen, I am for the concept of the plan, though without the details in front of me. We need to take these insolvent big banks down as a matter of sovereign right. We cannot let the international banking cartel continue to rob the treasury as first option.

Nov 01 12:55 PM