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

by: Rolfe Winkler, CFA

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.