Too Big To Fail: A Red Herring?

  by Elliott R. Morss

Introduction

In his latest report to Congress, Neil Barofsky, the Special Inspector General for Troubled Asset Relief Program (SIGTARP), bemoans the fact that nothing has been done to deal with financial institutions that are too big to fail (TBTF).

He quotes Kansas City Federal Reserve Bank President Thomas: “after this round of bailouts, the five largest financial institutions are 20 percent larger than they were before the crisis. They control $8.6 trillion in financial assets — the equivalent of nearly 60 percent of gross domestic product.” He also quotes MIT Professor Simon Johnson: “there is nothing [in the Act] that ensures our biggest banks will be safe enough or small enough or simple enough so that in the future they cannot demand bailout — the bailout potential exists as long as the government reasonably fears global financial panic if such banks are allowed to default on their debts.”

But are we missing the boat here? Is “too big to fail” the real policy problem, or is it just a cover for what really should be done to protect the world from another Western banking collapse?

 Barofsky’s Arguments

Barofsky makes several arguments for why action on TBTF is needed:

1.  For TBTF executives, “the Government safety net provides the motivation to take greater risks than they otherwise would in search of ever-greater profits. This ‘heads I win, tails the Government bails me out’ mentality promotes behavior that, while it may benefit shareholders and executives in the short term if the risks pay off, increases the likelihood of failure and, therefore, the possibility of another taxpayer-funded bailout.”

2.  TBTF gives these institutions a competitive advantage over smaller institutions. Creditors, knowing the TBTF institutions operate with a government safety net, “give them access to debt at a price that does not fully account for the risks created by their behavior. Cheaper credit is effectively a subsidy, which translates into greater profits, which allows the largest institutions to become even larger relative to the economy and materially disadvantages smaller banks.

3.  Rating agencies have started to include TBTF status in their ratings –Standard & Poor’s, will make permanent the prospect of Government support as a factor in determining a bank’s credit rating. S&P: “We believe that banking crises will happen again. We expect this pattern of banking sector boom and bust and government support to repeat itself in some fashion, regardless of governments’ recent and emerging policy response.”

Barofsky concludes:

“In short, the continued existence of institutions that are ‘too big to fail’ — an undeniable byproduct of former Secretary Paulson and Secretary Geithner’s use of TARP to assure the markets that during a time of crisis that they would not let such institutions fail — is a recipe for disaster. These institutions and their leaders are incentivized to engage in precisely the sort of behavior that could trigger the next financial crisis, thus perpetuating a doomsday cycle of booms, busts, and bailouts.”

 What’s Wrong with Barofsky’s Arguments?

Why are we concerned about large financial institutions to the point of providing them with a safety net? Because it is the job of the government to protect bank deposits. Who cares if some hedge fund, private equity group, or asset management company goes belly up? Let them.

In order to protect deposits, no bank, large or small, should be allowed to engage in risky business dealings. What should this mean? As I have written earlier, banks should:

 1. Manage their own loans – consider how bankers’ incentives change when, instead of managing their own loans and being dependent on repayments for survival, they sell them off for a commission (for more on this, see Amar Bhidé’s writings), and

 2. Earn less than 10% of their income from trading – trading is too dangerous for depository institutions, and no amount of bank regulation can deal with this – for the latest on what banks are proposing to get around trading restrictions in the Dodd-Frank Act, see Gretchen Morgenson’s latest article).

Implementing any sort of TPTF regulations raises complex policy problems too difficult to resolve. My solution?  Limit FDIC insurance to banks that agree to manage their own loans and engage in limited trading.

This might be all it would take to change “too big to fail” into “too big to exist”.  Asli Demirgüç-Kunt  and  Harry Huizinga recently summarized the numerous studies showing that banks larger than $25 billion to $50 billion in assets have degraded efficiency and poorer risk-return paramters.  If we remove the artificial support of these inefficiencies and risk, then the market should take care of the rest.  

TARP Bank Support– What Is Left

The Treasury has a site where you can see how bank bailouts are progressing.

A total of 739 banks got money – $374.8 billion.  Only 143 have fully repaid – $171.4 billion, or an average of $1.2 billion per bank.  Only17 have partially repaid and they were lent $784 million, or $46 million each. These 17 have repaid $331.3 million back, or slightly less than half.

 But 578 banks, 78% of the total, have not paid anything back yet. They received $30.4 billion, or $52.7 million each.  TARP funds are expensive for banks: they pay 5% for the first four years and 9% after that. The following table lists the top twenty borrowers. Of course, all bank deposits are insured. But to avoid any possible “inconveniences”, it is probably a good idea to avoid any bank that has not at least started to pay its TARP money back.

 Related Articles

Do We Need Big Banks  by Asli Demirgüç-Kunt and Harry Huizinga

Regulatory Reform of the Financial Industry – A Proposal  by Elliott Morss (at Morss Global Finance)

  Elliott Morss has a broad background in international finance and economics.  He holds a Ph.D. in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires.  During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries.  In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar.  He has co-authored seven books and published more than 50 professional journal articles.  Elliott writes at his blog Morss Global Finance.