Taking On the Notion of 'Too Big To Fail'

The financial crisis left the biggest U.S. banks bigger, and amplified concerns that these banks are TBTF: "Too Big to Fail." Calls for action to address TBTF were given considerable impetus by the recent annual report of the Federal Reserve Bank of Dallas, which asserted that "the vitality of our capitalist system" and "long-term prosperity" depend on eliminating TBTF. This in turn, according to the Dallas Fed, requires "breaking up the nation's biggest banks into smaller units."

The U.S. banking system is indeed dominated by six large firms accounting for more than half of bank assets. JPMorgan Chase and Bank of America had assets of more than $2 trillion each as of the end of 2011; Citigroup and Wells Fargo had more than $1 trillion each in assets; and Goldman Sachs and Morgan Stanley (formerly investment banks recast during the crisis as bank holding companies) weighed in at $950 and 800 billion, respectively. No other commercial bank comes close: the next largest has less than $400 billion in assets.

To be sure, there are many other large financial firms besides banks, including insurers and asset managers. But banks are special in that they intentionally undertake the risky activity of borrowing short-term money (deposits and other sources of funding) in order to invest in longer-term assets (such as making 30-year loans to homeowners). This maturity transformation at the heart of banking creates particular vulnerabilities to panics in which losses erode capital and confidence, and then funding vanishes and firms implode. This is a sadly familiar story, which too often during the recent financial crisis resulted in huge infusions of taxpayer money. The desire to end bailouts motivates many proposals to limit bank size.

Various provisions of the Dodd-Frank financial regulatory reform law and other regulatory initiatives such as the Basel III Accord impact large banks. Banks must hold more capital and ensure better access to liquidity. And then with the largest firms, those with assets of $50 billion or more, they're subject to an enhanced supervisory regime that includes both additional capital charges and other aspects of increased regulatory scrutiny. These steps are meant to ensure that firms have an increased buffer against losses and a greater ability to survive the strains of a future crisis, and thus to provide increased protection for taxpayers. Banks further face restrictions on their activities, notably including a prohibition on proprietary trading under the Volcker Rule. These measures provide a disincentive against size, though not an outright limit.

While Dodd-Frank does not actively seek to break up large banks, the recent regulatory process appears cognizant of the potential dangers posed by large financial institutions. The Federal Reserve's lengthy examination of the acquisition of ING Direct by Capital One, for example, suggested that regulators are wary of acquisitions that add bulk to already-large banks.

Still, the concern remains that policymakers will inevitably be forced to prop up a sufficiently large bank due to fear about the consequences of a failure. Hence the calls remain for further action to address TBTF.

What is sometimes overlooked in the discussion of TBTF is that the new orderly liquidation authority in Title II of Dodd-Frank fundamentally changes the way in which future problems at large financial institutions will be handled, and that this in turn has a profound impact even today, before a crisis. The Dodd-Frank resolution authority makes clear to bondholders and other creditors that they will take losses if a firm fails. Government money can be used to support a firm, but these funds must then be repaid by bondholders after shareholders are wiped out. Absent additional Congressional action (which is hard to imagine given the unpopularity of the TARP), a future failure of a large financial institution will involve losses for bondholders. This contrasts with what generally happened during the recent crisis, in which support for bondholders was the most common bailout.

While it is difficult to know in advance how the resolution authority will be used, it seems likely that the experience of the problems following Lehman's demise will lead the FDIC, which will typically be in charge, to initially deploy government funds to keep a firm in operation in resolution. The FDIC might then arrange a debt-for-equity swap that recapitalizes the failing firm, with the former bondholders as the new owners.

This would be similar to a pre-packaged Chapter 11 reorganization under the bankruptcy code, though the Title II authorities would allow this to be done faster and with the government providing the equivalent of debtor-in-possession financing. Losses ultimately would be borne by bondholders.

The resolution authority provides government officials with an open checkbook to act through the troubled firm, with bondholders picking up the tab. The legislation seeks to narrow the scope of action for the FDIC in resolution by guaranteeing bondholders that they will receive as much in resolution as would have been the case under bankruptcy.  Of course this still gives worrisome scope for mischief on the part of policymakers.

The key reason while resolution authority gets at TBTF is that the near-certainty of taking losses translates into higher funding costs even in normal times (with no crisis). This reduces or even reverses the previous advantage of large firms reflecting the belief that bondholders would be bailed out. There will still be government action if large banks get into trouble: indeed, Dodd-Frank institutionalizes the intervention. But losses will be imposed. Ending the bailout of creditors such as bondholders removes a key problem of having institutions that are too big to fail.

The regulatory regime for large, complex financial institutions is in the process of a vast change from the system that prevailed before the financial crisis. Firms will be required to hold more capital, have more robust access to liquidity, receive increased regulatory scrutiny, and face restrictions on their activities. These changes will involve costs and benefits. Higher capital and liquidity requirements, for example, will affect lending activity and thus the overall economy, but the quantitative impact remains to be seen.

The Dodd-Frank legislation has many problems and omissions, and much is still uncertain about implementation. But the new liquidation authority provides for the possibility of making it so that future crises do not involve the bailouts of creditors that truly embodied the problem of having banks that are too big to fail.