The "Political Reality" of Too Big to Fail

What do we do about "too big to fail"?

"Too big to fail," or TBTF as it has been acronymized, is the official unofficial doctrine of our top financial regulators. It is the idea that a small number of giant banking institutions are so big and so interconnected with so many different parts of the economy that they can never be allowed to go bankrupt. They must be propped up or bailed out at all costs, on the theory that if they fail, they will take the whole economy down with them.

This is how we ended up doling out a trillion dollars in bailouts in 2008-2009, and while the Dodd-Frank financial regulations passed in President Obama's first term were billed as an attempt to end TBTF, it is widely acknowledged that they did no such thing--which sets us up for another bailout crisis, possibly an even bigger one, in the future.

Firms deemed too big to fail become de facto government-sponsored entities. Because everyone assumes they will be bailed out if they run into trouble, they are able to ride off the credit rating of the federal government while still being privately owned and run. This means that the shareholders and managers of these banks--especially the managers--enjoy the economic advantages that come from an implicit government guarantee, while taxpayers are left holding the bag if things go wrong. In the balance between risk and reward, the reward is private while the risk is public.

This has two perverse effects that immediately make the problem much worse. When a firm becomes too big to fail, the subsidy that comes with government backing and the competitive advantage this gives it over smaller banks cause the firm to become even larger. So it goes from being too big to fail to being really too big to fail. Yet at the same time, the safety net of a government bailout gives the bank's managers an incentive to take on more risk. It frees them to chase higher returns (and bigger bonuses) without facing pressure from risk-averse shareholders or trading partners.

So we confront the problem of banks so big that they could destabilize the financial system--and we react by making them even bigger and less stable.

And that's just the beginning. We face an even worse set of dilemmas when we contemplate how to end too big to fail.

In short, TBTF is FUBAR.

You can get an appreciation of how "fouled up" this issue is by looking at a proposal from Richard Fisher, president of the Federal Reserve Bank of Dallas, on how to end "too big to fail."

Fisher explains all of the negative consequences of "too big to fail" that I have described above. But he argues that the government cannot credibly declare an end to too big to fail because the largest banks really are too big to fail. Only 12 of these "megabanks" have 69% of the assets in the banking industry. If the government decided to let one of them fall, the consequences of the collapse would mount, and so many financial institutions would be screaming for relief that the Federal Reserve and the Treasury would be pressured into a bailout. So for the country's giant banks, he argues, the threat of failure is not really credible. No political leader would have the guts to sit back and let it happen.

So Fisher's solution is to whittle down the megabanks until they are small enough to fail.

"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.

"[This proposal] calls first for rolling back the federal safety net to apply only to basic, traditional commercial banking. Second, it calls for clarifying, through simple, understandable disclosures, that the federal safety net applies only to the commercial bank and its customers and never ever to the customers of any other affiliated subsidiary or the holding company. The shadow banking activities of financial institutions must not receive taxpayer support.

"We recognize that undoing customer inertia and management habits at TBTF banking institutions may take many years. During such a period, TBTF banks could possibly sow the seeds for another financial crisis. For these reasons, additional action may be necessary. The TBTF [bank holding companies] may need to be downsized and restructured so that the safety-net-supported commercial banking part of the holding company can be effectively disciplined by regulators and market forces....

"We believe that market forces should be relied upon as much as practicable. However, entrenched oligopoly forces, in combination with customer inertia, will likely only be overcome through government-sanctioned reorganization and restructuring of the TBTF BHCs. A subsidy once given is nearly impossible to take away. Thus, it appears we may need a push, using as little government intervention as possible to realign incentives, reestablish a competitive landscape and level the playing field."

Note that Fisher is trying to make a free-market argument for breaking up the big banks. There are folks on the left who propose breaking up the banks, but mostly just to punish them for the sins of being big and being banks. By contrast, Fisher is proposing a breakup as part of a real, serious plan to end too big to fail and to establish a credible ban on bailouts.

We certainly should be talking about this kind of proposal, because too big to fail is not over. It will eventually come roaring back in the form of a new crisis, and everyone will suddenly be shocked that we're bailing out the banks again.

We can be pretty certain that there will eventually be a new crisis, because the current system relies on financial regulators to act as omniscient central planners. But as Floyd Norris recently noted in the New York Times, there are big questions about whether the models used by financial regulators can actually measure the risks we would face in a crisis.

The contradiction of financial regulation is to assume that the guys at JP Morgan and Goldman Sachs don't know how to manage their own risks--but the guys at the Federal Reserve and Treasury Department do know. It is even more absurd when you consider the revolving door between Washington and Wall Street, so that many of the regulators who are supposed to know better than the guys on Wall Street were the guys on Wall Street just a year or two earlier.

But that same point highlights the problem with breaking up the big banks as an antidote to too big to fail. This breakup is also an exercise in central planning. Regulators would have to determine which banks are "too big" and how many pieces they should be broken into. In the process of breaking them up, of dissolving a complex network of financial relationships among the big banks' subsidiaries, they would run the risk of creating new business entities that are not viable outside of their old relationships--and thereby precipitating precisely the series of failures they sought to avoid.

More important is the fact that you can't do this just once. It has to become an ongoing form of central planning. Having broken up banks that were too big to fail, regulators then have to prevent them from ever become too big again. So instead of regulators trying to divine which of the big banks' policies might create excessive systemic risks, they would be trying to gauge how big a bank can become before it poses a systemic risk. The danger is that we end up with a new level of regulation on top of all of the other banking regulations. It reminds me of the way the breakup of AT&T was managed. It was not just a one-time deal. For more than a decade, the activities of the Baby Bells were managed under the authority of the court's consent decree, with a federal judge deciding what mergers and what business policies he would permit.

That's what happens when you try to fix one form of government regulation with another form of government regulation. Sir Walter Scott wrote, "Oh, what a tangled web we weave, when first we practice to deceive." The modern corollary might be, "Oh, what a tangled web we create, when first we choose to regulate."

Fisher's proposal certainly deserves attention. He has made a real attempt to mitigate the negative consequences and simplify the regulatory environment for the new, small-enough-to-fail banks. It may well be the best answer to an awful dilemma. Remember, though, that the purpose of his proposal is to take account of the "political reality" that it is impossible to credibly revoke the too big to fail subsidy. But if we're looking at "political reality," we also have to recognize that no one is going to act on Fisher's proposal or anybody else's.

Who built the current system of too big to fail? President Obama, the Democratic leadership in the Senate, and the powers that be at the Treasury and the Federal Reserve, all of whom are still in power. Consider the fact that Tim Geithner, one of the architects of the bailouts, is being openly considered for Ben Bernanke's job at the Fed--an indication that the people now in charge have no interest in changing the system. So for the foreseeable future, coming up with a way to end too big to fail is something of an academic exercise.

I suspect that nothing is going to happen until we have another crisis, and any solution we come up with will have to be revised in the context of whatever that new crisis turns out to be.

In the meantime, we can debate proposals like Fisher's--but we can also work to change the "political reality" on which it is based. The widest "political reality" of too big to fail is the expectation that the government's job is to serve as our backstop and guarantor for every aspect of life. If it's there to insure our health and our retirement and our kids' college education, and everything else, then it's also going to be there to keep our banks from having to face the music. And it always will be, no matter what regulations we try to put in place to prevent it, so long as we regard it as the government's job to outlaw failure and risk.

The theme of President Obama's second inaugural address was the harnessing of the "collective," as represented by government, to shield the individual from the vicissitudes of life--which is a perfect description of the premise behind too big to fail. So if we want to end too big to fail, we might get the best results if we start by debating that deeper philosophical assumption.