Too Big to Fail

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The Too Big to Fail policy is the idea that in economic regulation the largest and most interconnected businesses are "too big to [let] fail." This means that it might encourage recklessness since the government would pick up the pieces in the event it was about to go out of business. [1]

The phrase has also been more broadly applied to refer to a government's policy to bail out any corporation. It raises the issue of moral hazard in business operations.

The term is back to central stage since the start of the financial meltdown. The most important US company referred to as too big to fail is American International Group (AIG).

Some critics see the policy as wrong and counterproductive. They think big banks should be left to fail if their risk management was not effective.[2]

See also Break up banks, leverage, Narrow banks, Resolution authority and Volcker plan.


Congressional considerations

Dodd-Frank on too-big-to-fail

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("the Act") begins sweeping reform for the U.S. financial system. It requires new and existing regulatory agencies to undertake more than 50 studies of the financial system and more than 250 instances of rulemaking. Duane Morris has issued further Alerts on many of the broad topics addressed by the Act, accessible at

Title II of the Act, designated "Orderly Liquidation Authority" – effective July 21, 2010 – establishes what is intended to be an orderly liquidation process for "financial companies" whose collapse or potential collapse are determined to constitute a risk to the financial system as a whole. Such systemically significant institutions would be liquidated under these new procedures, rather than being treated under existing bankruptcy laws. (The intent of Act is that most-failing financial companies will continue to be administered under existing bankruptcy laws.)

A "financial company" is defined as any of the following:

  • A bank holding company (as defined in the Bank Holding Company Act of 1956);
  • A company that (A) derives 85 percent or more of its annual gross revenues from, or of which at least 85 percent of its consolidated assets are related to, activities that are financial in nature (as defined in the Bank Holding Company Act – this would include, among other things, lending; exchanging; transferring; investing for others; insuring or indemnifying against loss, harm or damage; acting as principal, agent or broker; underwriting, dealing in or making a market in securities; or providing financial, investment or economic advisory services); and (B) the newly created Financial Stability Oversight Council, by a vote of at least two-thirds of its nine members (including the chairperson, the Secretary of the Treasury), determines should be supervised by the Board of Governors of the Federal Reserve System (the "Board of Governors") because its failure or financial distress could pose a risk to the financial stability of the United States;
  • Any company predominantly engaged in activities that the Board of Governors has determined are financial in nature (for purposes of the Bank Holding Company Act); and
  • Any subsidiary of any company described above that is predominantly engaged in activities that Board of Governors has determined are financial in nature or incidental thereto for purposes of the Bank Holding Company Act (excluding subsidiaries that are insured depository institutions or insurance companies).

If the Treasury Secretary, in consultation with the President (and following receipt of a recommendation described in the next paragraph), determines that a financial company is in default or is in danger of default and, among other things, that the failure of the financial company would have significant adverse effects on financial stability in the United States, the Secretary must notify the company of such determination and of its intention to appoint the FDIC as receiver. (Such a determination may occur before or after a financial company has commenced bankruptcy proceedings.)

If the board of directors of the subject company consents to such appointment, the Treasury Secretary is required to appoint the FDIC as receiver. (The Act creates a specific safe harbor providing that the members of the board of directors of a financial company will not be liable to the company's shareholders or creditors for acquiescing in or consenting in good faith to the appointment of the FDIC as receiver.)

Absent such consent, the Treasury Secretary is required to file a sealed petition with the U.S. District Court for the District of Columbia (the "District Court") seeking an order authorizing the Secretary to appoint the FDIC. The petition will be granted by operation of law within 24 hours after filing unless the District Court rules that the Treasury Secretary's determinations that the company in question is a financial company and is in default or may potentially default were "arbitrary and capricious." The "arbitrary and capricious" standard appears to give the Secretary considerable discretion in making its determinations and will be difficult for a company to overcome.

The Treasury Secretary cannot make a determination described in the previous paragraph unilaterally. The Secretary must first receive a recommendation from the Board of Governors and from the FDIC, based upon a vote of at least two-thirds of the Board of Governors and the board of the FDIC, unless (a) the company in question is a broker dealer, in which case, the written recommendation must come from the SEC and from the Board of Governors, upon votes of at least two-thirds of the members of the SEC and the Board of Governors; or (b) the company in question is an insurance company, in which case, the director of the Federal Insurance Office and the Board of Governors, based on a two-thirds' vote, must make the recommendation. (The Federal Insurance Office is a new office established by the Act within the Department of the Treasury for the purpose of monitoring the insurance industry.)

The Treasury Secretary or the affected company may, no later than 30 days after the date of the District Court's ruling, file an appeal of such ruling with the U.S. Court of Appeals for the D.C. Circuit ("Court of Appeals"), and such an appeal must be considered on an expedited basis. However, if the District Court grants the Secretary's petition, the FDIC's authority to begin acting as receiver will commence immediately – the District Court's decision is not subject to any stay or injunction pending the appeal. Thus, it is possible that the orderly liquidation process could be under way by the time the Court of Appeals issues a ruling. The Court of Appeals' scope of review is limited to deciding whether the Treasury Secretary's determinations that the company fits the definition of a "financial company" and is in default or in danger of default were arbitrary and capricious.

As a result of this new orderly liquidation regime, creditors of and other transactional counterparties with systemically important financial companies will need to consider, as part of their risk assessment, the possibility that the financial company may enter bankruptcy proceedings, or instead may become subject to the liquidation process under the Act, and to consider how their rights may differ under each scenario.

The FDIC, acting as receiver, has a broad array of powers over the financial company. These powers are similar to those the FDIC has over failed FDIC-insured depository institutions, with some differences. The Act states that, in taking actions as receiver, the FDIC must, among other things:

  • Ensure that the shareholders of the financial company do not receive payment until after all other claims and the "Orderly Liquidation Fund" (see below) are fully paid;
  • Ensure that unsecured creditors bear losses in accordance with the applicable priority of their claims;
  • Ensure that the members of the board of directors and the management of the financial company who were responsible for the failed condition of the company are removed; and
  • Not take an equity interest in or become a shareholder of the financial company.

The Act notes that all companies placed into receivership under the Act's provisions should be liquidated, and that no taxpayer funds should be used to prevent any such liquidation.

A new segregated fund, called the Orderly Liquidation Fund, has been established to enable the FDIC to carry out its authorities under Title II of the Act. Once the FDIC submits to the Treasury Secretary a plan for the orderly liquidation of a financial company satisfactory to the Secretary, the FDIC may issue obligations to the Treasury Secretary, the proceeds of which are deposited into the Fund until needed. The maximum amount of obligations that the FDIC may issue with regard to a financial company may not exceed 10 percent of the total consolidated assets of the financial company during the first 30 days of liquidation proceedings, and may not exceed 90 percent of the fair value of the total consolidated assets of the financial company available for repayment following the initial 30-day period. Obligations so incurred by the FDIC have priority over other claims against the company, including administrative expenses.

If necessary in order to enable the FDIC to repay its obligations to the Treasury within 60 months of the date of issuance, the FDIC is required to impose assessments (i) on any claimant of the financial company that received amounts in excess of liquidation value of its claim; and if this is not sufficient to enable the FDIC to recover the amount of its obligations, (ii) on financial companies having consolidated assets of $50 billion or more and nonbank financial companies supervised by the Board of Governors. Any assessments on such financial companies are to be made on a graduated basis, with companies having greater assets and risk being assessed at a higher rate.

Title I of the Act includes provisions permitting the Board of Governors, in certain instances, to break up certain large, complex financial institutions even if they are not insolvent. If the Board of Governors determines that a bank holding company with total consolidated assets of $50 billion or more or a nonbank financial company that is under the supervision of the Federal Reserve poses a "grave threat"1 to U.S. financial stability, the Board of Governors, following an affirmative vote of at least two-thirds of the voting members of the Financial Stability Oversight Council, is required to:

  • Limit the ability of the company to merge, consolidate or otherwise become affiliated with another company;
  • Restrict the ability of the company to offer one or more financial products;
  • Terminate one or more activities of the company; and
  • Impose conditions on the manner in which the company conducts one or more activities.

If the Board of Governors is considering such mitigatory action against a company, it is required, in consultation with the Financial Stability Oversight Council, to notify the institution and provide an explanation of the basis for its proposed mitigatory action. The company may, no later than 30 days after the date of receipt of such notice, request an opportunity for a hearing before the Board of Governors to contest the proposed mitigatory action. The Board of Governors must issue a final decision no later than 60 days following such a hearing (or, if no hearing was held, the date of its notice to the company). Unlike the process described in Title II for the appointment of the FDIC as receiver of a failing or failed financial company, the Act does not specify a judicial appeal process of a final decision of the Board of Governors.

Kanjorski amendment requires affirmative systemic risk determination

The bank lobbyists, it turns out, missed one. They and their congressional allies were able to gut the Volcker Rule, the Lincoln Amendment, and almost everything else that could have had a meaningful effect on the industry.

But, as I point out in a Bloomberg column today, they couldn't get at (or didn't sufficiently understand?) the Kanjorski Amendment. This Amendment was originally proposed by Congressman Paul Kanjorski (chair of an important House subcommittee on capital markets) during the fall. Against the odds, it survived in the final House bill and now -- probably because it has stayed mostly below the radar -- remains in the reconciled legislation.

Kanjorski gives federal regulators the power and the responsibility to limit the activities or even break up big banks if they pose a "grave risk" to the financial system.

The Federal Reserve is in the hot seat on this issue -- and it needs 7 out of the 10 members of the new systemic risk council to agree to any action. But for the first time someone at the federal level must make a determination regarding whether an individual firm poses system risk.

And congressional committees can call upon the responsible people to explain how they determine whether a megabank is or is not dangerous. What are the risk metrics they use? To what extent do they take on board outside opinions? How much do they consult with the bank itself?

This also creates important space for critics. There are many people -- outside of the big banks -- working on developing ways of assessing system risk. Again, congressional hearings can raise the prominence and credibility of this work. The question will be: If the regulators are not taking these perspectives into account, why not?

This may all sound rather technical, and to some extent it is. But it is also intensely and pointedly political. The Kanjorski Amendment makes it clear that system risk must be assessed and dealt with. And it assigns clear responsibility for this issue -- along with a cut and dried list of remedies.

The debate on big banks and the dangers they pose is far from over.

Brown says he lacks votes on 'too big to fail' amendment

"Sen. Sherrod Brown (D-Ohio) said he lacks the votes right now to advance his amendment limiting the size of banks.

Brown held out hope that the measure, which he's offered along with Sen. Ted Kaufman (D-Del.), could win enough support to pass as the Senate debate moves forward.

"I don't think we do yet," Brown told Bloomberg's "Political Capital" when asked if he has the votes. "I think a week ago we weren't even close. I think this weekend we're closer."

The Senate will take up a variety of amendments starting this week on amendments to Democrats' Wall Street reform bill. The amendment that's been offered by Brown and Kaufman would place hard caps on the size of banks and the extent to which they can use leverage.

Other senators have been more reluctant to sign onto such language. Sen. Mark Warner (D-Va.), for instance, said this weekend on C-SPAN that he believes the size of firms isn't what matters, but rather, how well-regulated they are.

Brown and Kaufman's effort is aimed at quelling concerns over firms that are "too big to fail," or holding so many assets and complex contracts that their failure would have a cascading effect throughout the financial industry.

Still, Brown held out hope that more aggressive messaging would help win his colleagues over when it comes to backing their amendment.

"I think that by next week, as people have watched the Goldman hearings, as people hear these statistics -- like 63 percent of GDP, their combined assets -- as people hear the debate on this, I think senators in both parties increasingly are going to join Sen. Kaufman and me on moving forward with this," he said.

Brown amendment to cap bank size at 2% of GDP

A group of Senate Democrats introduced a bill on Wednesday that would require the nation’s three largest banks to shrink, in an effort to eliminate the problem of financial institutions being seen as “too big to fail.”

Their proposal, which would put specific ceilings on the size of banks, builds on a provision already in the Senate’s financial regulatory overhaul package that is meant to limit future growth of large Wall Street firms.

“The major issue is to keep the banks from getting too large to begin with,” the lead sponsor of the bill, Senator Sherrod Brown, Democrat of Ohio, said Wednesday morning. “Too big to fail is too big. That’s where we need to be much more aggressive.”

As concern about the risk posed by the biggest financial institutions percolates among populists in Congress and at the Federal Reserve, the lawmakers plan to offer the bill as an amendment to the pending Senate legislation, which could reach the floor as soon as Monday.

The bill would cap the amount of non-deposit liabilities of any one bank — effectively, the amount the bank borrows in various ways to finance its operations — at an amount equal to 2 percent of the nation’s gross domestic product, a measure of the size of the economy. For major financial firms that are not banks, like AIG, Metropolitan Life or the financial arm of General Electric, the cap would by 3 percent of G.D.P.

The bill would reinforce a 1994 law that bars any single bank from holding more than 10 percent of the nation’s total deposits, or about $750 billion. In the years since then, large firms have obtained waivers or used loopholes in the law to exceed that ceiling. Three institutions — Bank of America, Wells Fargo and J.P. Morgan Chase — are over the limit now, and would have to shed the excess within three years.

A number of Republicans have expressed concern about the size issue, and Mr. Brown appeared optimistic Wednesday that his provision could win Republican support.

“I would challenge any Republican to co-sponsor this issue,” he said. “If they are really concerned about ‘too big to fail,’ they should want to keep them from getting that big in the first place.”

Senator Ted Kaufman, Democrat of Delaware, who is a co-sponsor of the bill, said that the Federal Reserve has had the power to limit the size of banks since 1970, but has not acted. Instead, the nation’s six largest bank holding companies — Citigroup, Goldman Sachs and Morgan Stanley are the other three — have only grown bigger over the last year and a half, mainly as a result of government-brokered mergers. They can now borrow at significantly lower rates than their smaller competitors, a result of the bond market’s implicit assumption that the government will never allow them to fail.

Treasury Department and Federal Reserve officials have rejected calls to break up the biggest financial institutions, saying bank size alone is not the most important threat.

Senator Brown offers amendment to reduce bank size

Not one to let a good crisis go to waste, Bank of America managed, in the dark days of 2008, to parlay its own insolvency and near collapse into attaining something it had long dreamed of: federal approval to bypass a national law that says that no bank may acquire another bank if it would end up holding more than 10 percent of the country's deposits.

For years, Bank of America had hovered on the 10 percent threshold. Its acquisition of Fleet Boston in 2004 put it over the line and should have been prohibited, but Bank of America, with the Federal Reserve's blessing, came up with a clever way to do the math. By counting all the deposits held in U.S. territories, like Guam and Puerto Rico, Bank of America inflated the national deposit total enough to limbo-dance its way under the bar. Similar contortions allowed it to acquire LaSalle Bank in 2007.

Fearing that it would be barred from buying up more banks, Bank of America began to lobby Congress to abolish the cap. Just a year before it helped bring the U.S. economy to its knees, Bank of America was circulating a position paper that characterized the size cap as "antiquated" and "conceptually flawed."

It didn't get very far with lawmakers. But what lobbying failed to accomplish was soon made possible by crisis. As the financial collapse unfolded, regulators made the astonishing decision that the way to deal with failing mega-banks was not to distribute their assets among smaller institutions, but to merge them with one another. Bank of America absorbed Countrywide and Merrill Lynch, and swelled to 12 percent of U.S. deposits. Wells Fargo crossed the 10 percent line when it took over Wachovia in 2008. JP Morgan Chase, fattened on Washington Mutual and Bear Sterns, emerged from the crisis holding 9 percent of our deposits.

Reestablishing a cap on the size of banks - one small enough not only to limit mergers among giants in the future but to require an orderly break-up of the biggest banks - ought to be a key pillar of financial reform. It's by no means the only policy needed to curtail systemic risk and rebuild a community-oriented financial system, but it is easily the best and most straightforward tool we have for constraining the concentration of banking power.

Dodd's financial reform bill lacks a hard cap on bank size, but an amendment put forward by Senator Sherrod Brown of Ohio would strictly limit the size of banks and, if enacted, entail breaking the country's largest banks into several pieces.

Brown's proposal fixes several flaws in the current deposit cap, which Congress adopted in 1994 as part of a sweeping deregulation bill that allowed banks to merge and expand across state borders with virtually no restrictions. The cap was added to the bill in order to appease public concerns that a few banks would become too large and powerful. (Those concerns proved well-founded. When the law passed, the top five banks together held 12 percent of U.S. deposits. A mere fifteen years later, the top five account for nearly 40 percent of deposits. See our charts for more detail.)

One problem with the current size limit is that it permits a bank to exceed the cap if it acquires a financial institution that is either in danger of going under or is organized as something other than a commercial bank, such as a savings and loan. These were the loopholes that allowed the Federal Reserve to escort Bank of America and Wells Fargo over the limit in 2008.

Another problem is that the cap applies only to deposits. As Simon Johnson, former chief economist of the International Monetary Fund, has noted, the big commercial banks have funded much of their recent growth not with deposits, but with various forms of wholesale financing. The same is true of investment banks, which do little in the way of basic consumer banking and thus can grow to a massive size without running afoul of the cap.

Most important, the current cap is simply too generous. It has already allowed banks to expand to dangerous proportions, exacting ever higher fees from consumers and limiting the flow of credit to small businesses. It could permit as few as ten banks to control our entire financial system.

Brown's amendment would prohibit banks from growing - either on their own or through acquisitions - to the point where their non-deposit liabilities (including off-balance sheet liabilities) amount to more than 3 percent of the country's gross domestic product.

Brown's cap does not allow any exceptions. It mandates that banks that are over the limit divest some of their assets or otherwise shrink. Its passage would entail downsizing at least five of the country's largest banks. Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase and Morgan Stanley, all of which now have non-deposit liabilities in the neighborhood of 5-8 percent of GDP, would each need to be split into two or three separate entities.

Opponents will undoubtedly characterize Brown's amendment as radical, but it is hardly so. It would simply return us to a industry configuration similar to the mid-1990s when banks were plenty large.

What is truly, and dangerously, radical is the notion that today's inflated banks, which not only wrecked the economy but used the crisis to expand their market power, should be allowed to set a new status quo for bank size. As Senator Edward Kaufman of Delaware said in a speech earlier this month, "Given the high costs of our policy and regulatory failures, as well as the reckless behavior on Wall Street, why should those of us who propose going back to the proven statutory and regulatory ideas of the past bear the burden of proof? The burden of proof should be upon those who would only tinker at the edges of our current system of financial regulation."

Kanjorski amendment to dismantle TBTF

A House committee approved giving the U.S. authority to break up healthy, well-capitalized firms whose size threatens the economy, a step Republicans said would create a “huge accumulation” of power.

The House Financial Services Committee voted 38-29 today on an amendment that would let regulators dismantle a firm, limit mergers and acquisitions and force an end to activities deemed systemically risky. The financial industry opposed the measure, which is part of legislation to overhaul Wall Street rules.

“I recognize this is extraordinary power,” Representative Paul Kanjorski, a Pennsylvania Democrat who proposed the amendment, said during debate. “Hopefully it will never have to be used because it is displayed and because it does exist.”

The House Financial Services Committee is considering legislation that would create a council of regulators, including the Federal Reserve, to monitor large, interconnected firms for risks they pose. It’s part of the effort in Congress to overhaul financial rules to prevent a repeat of the worst financial crisis since the Great Depression.

Republicans opposed Kanjorski’s plan as giving too much authority to regulators.

“That’s a huge accumulation of power that we’re going to give to five or six people that are on this council,” said Representative Randy Neugebauer, a Texas Republican. “We’re already imposing the federal government substantially on these entities.”

Industry Opposition

Representative Spencer Bachus of Alabama, the committee’s top Republican, said the plan entrusts regulators to decide “what the financial industry should look like” and those agencies failed to anticipate the crisis, “let alone do anything to prevent it,” Bachus said.

The Financial Services Roundtable, representing the biggest financial firms, and the Financial Services Forum also opposed the legislation.

Kanjorski’s measure would empower the council to break apart firms considered well-capitalized if they are “so large, interconnected or risky that their collapse would put at risk the entire American economic system,” according to a bill summary released by Kanjorski’s office.

The measure requires the council to consult with the president before taking “extraordinary” actions. The amendment doesn’t cap the size of financial firms, the summary said.

The council would give Congress an annual report showing the size, concentration and links with other firms for the 50 largest U.S. financial institutions based on assets.

Kanjorski has met some of the heads of firms that would be covered by the council and said he are is aware of the controversy the proposal has stirred.

‘Contentious Amendment’

“I don’t want to kid anybody,” Kanjorski said. “This is a contentious amendment.”

Kanjorski’s proposal will discourage financial firms from expanding, said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, representing many large U.S. financial firms in Washington.

While a policy of having government prop up systemically important firms must be eliminated, targeting an institution’s size isn’t the solution, said Rob Nichols, president of the Financial Services Forum.

“More effective supervision, coupled with the authority to seize and wind down large firms, is the appropriate remedy,” Nichols said.

Lawmakers are seeking to prevent further taxpayer bailouts after last year’s rescues of American International Group Inc., Citigroup Inc. and Bank of America Corp. under the $700 billion Troubled Asset Relief Program.

The committee plans to vote on Kanjorski’s amendment later today. The legislation must be passed by the House and Senate and signed by the president to become law.

House Financial Services hearing on systemic risk Sept 24

  • Testimony: The Honorable Paul Volcker, Former Chairman of the Board of Governors of the Federal Reserve System
  • Testimony: The Honorable Arthur Levitt, Jr., Former Chairman of the United States Securities and Exchange Commission, Senior Advisor, The Carlyle Group
  • Testimony: Mr. Jeffrey A. Miron, Senior Lecturer and Director of Undergraduate Studies, Department of Economics, Harvard University
  • Testimony: Mr. Mark Zandi, Chief Economist, Moody’s
  • Testimony: Mr. John H. Cochrane, AQR Capital Management Professor of Finance, The University of Chicago Booth School of Business

Joint Economic Committee of Congress hearing on TBTF

The Joint Economic Committee (JEC), chaired by Congresswoman Carolyn B. Maloney, held a hearing on Tuesday, April 21, 2009.

At the hearing, entitled “Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions,” economists including Joseph Stiglitz and Simon Johnson focused on new policy responses to failures at large financial institutions. The hearing examined what criteria policymakers and regulators should use to determine when institutions pose systemic risk – at what point financial firms become ‘too big to fail’ – and how regulators should deal with them when they are insolvent.

Click here to watch an archived video of the JEC hearing.

House Judiciary hearing on bankruptcy and TBTF

"Yesterday afternoon, the House Judiciary Committee held Part II of its series of hearings entitled “Too Big to Fail – the Role for Bankruptcy and Antitrust Law in Financial Regulation Reform.” Yesterday’s hearing focused on proposed financial regulatory reform, particularly with respect to institutions that may be regarded as “too big to fail.”

The following witnesses testified before the Committee:

  • Christopher L. Sagers, Associate Professor of Law, Cleveland-Marshall College of Law;
  • Edwin E. Smith, Bingham McCutchen, LLP, on behalf of the National Bankruptcy Conference;
  • Michael A. Rosenthal, Gibson, Dunn & Crutcher, LLP; and
  • Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia Business School.

The witnesses cautioned lawmakers that plans to create an alternative to bankruptcy could dissuade investors from providing future credit to unstable financial institutions.

Professor Sagers spoke generally on antirust aspects of Titles VII and XIII of the Administration’s financial reform proposal, the the Over-the-Counter Derivatives Markets Act of 2009 and the Resolution Authority for Large, Interconnected Financial Companies Act of 2009, and the ways each proposal would modify the antitrust laws. He noted that there were specific and technical antitrust issues in both proposals and “an overarching antitrust problem as to the Administration’s entire financial reform packages.”

Mr. Smith, who serves as Chair of the Capital Markets Committee of the National Bankruptcy Conference, told the subcommittee that the Conference generally supports the “promulgation of a statutory and regulatory scheme by which federal regulatory agencies would be able to identify” large financial institutions and their affiliates whose collapse could threaten the stability of U.S. and international capital markets. Although the proposed framework would empower federal agencies to “rescue the core business of the identified financial institution and its affiliates with a view to mitigating or even eliminating that risk,” Mr. Smith said that the Conference believed that the winding down of a troubled institution should be handled under the Bankruptcy Code. If a separate resolution scheme is created, which institutions are subject to the scheme must be transparent and the scheme must provide clear rules that are fair to creditors. Absent those features, the new scheme is likely to unsettle extenders of credit to affected financial institutions, and create more uncertainty in the markets.

Mr. Rosenthal said that lawmakers must first acknowledge that “creating a system to manage the failure of our largest financial participants” is complicated due to the “incredible diversity of transactions in which systemically-significant institutions engage in today’s marketplace [which] demand a highly nuanced and transaction-specific approach to resolve the rights of creditors, debtors, and taxpayers, at the same time, preserve systemic stability.” He further noted that future government intervention must be more predictable and that “the ability to foresee, plan, and reserve for known risks is crucial to overall market stability.” Mr. Rosenthal emphasized that “[a]bsent compelling public policy reasons to the contrary, we should base a new system as much as possible on what the market knows and understands,” which include the Federal Deposit Insurance Act (in the case of failing financial institutions) and the Bankruptcy Code (in the case of other failing businesses).

Mr. Calomiris stated that in the wake of the AIG and Bear Stearns bailouts and Lehman bankruptcy “[r]eform must create a means to transfer the control of assets and operations of a failed institution in an orderly way, while ensuring that shareholders and creditors of the failing firm suffer large losses.” He noted that such outcomes are “essential if resolution of failure is to avoid significant distributions to third parties, and also avoid bailout costs to taxpayers and accompanying moral-hazard costs.

Experts say bills won't end "too big to fail"

We at Planet Money did an informal survey of economists and regulatory experts on the left and the right. We couldn't find any who fully endorse the reforms backed by President Obama and Democrats in Congress.

Everyone thinks the reforms just aren't enough to solve the problem.

Take, for example, "too big to fail" -- the idea that if one of the largest banks in the country gets into trouble, the government will save it with taxpayer money.

"A vote for reform is a vote to put a stop to taxpayer-funded bailouts," Obama said in his speech in New York on Thursday.

I cannot find any experts -- of any party -- who are willing to agree with Obama on this one.

"We're not seeing a very forceful step on the too-big-to-fail-problem," said Carmen Reinhart, an economist at the University of Maryland. "If there's any doubt that the crisis may be systemic, we will bail out again."

So, if a major bank says, "Hey, save us or the economy will go under," the government's going to save the bank. Full stop.

We did find one expert, Doug Elliott of the Brookings Institution, who is actually a huge fan of the regulatory reform bills. He says they bring a bunch of changes that make our economy safer.

But they don't end too big to fail, he said. The only way to do that is to break them up so that "they're so small that we don't care" if they fail.

This is close to a consensus view among the experts. Some say that's a good idea, some say it isn't. But most say that unless you chop up the big banks into lots of small banks, you won't end too big to fail.

Financial Crisis Inquiry Commission on TBTF

The purpose of this preliminary staff report is to describe governmental rescues of financial institutions during the decades leading up to the financial crisis and during the crisis itself.

Section I provides an executive summary of the report.

Section II describes how federal regulators justified their rescues of large, failing commercial banks prior to 1991 by invoking a rationale commonly referred to “too-big-to-fail” or TBTF.

Section III discusses how Congress attempted to narrow the scope of the TBTF rationale in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), and how TBTF considerations continued to affect the banking system despite FDICIA.

Section IV focuses on two government-sponsored enterprises, Fannie and Freddie, and explains why those enterprises were viewed as presumptively TBTF prior to the financial crisis.

As Section V explains, interventions by federal regulators in the capital markets between 1970 and 1998 raised questions about whether the federal government might be prepared to support large, nonbank financial institutions during a systemic crisis.

Section VI describes how federal regulators and Congress greatly expanded the application of the TBTF policy and created new policy instruments to support large banks, Fannie, Freddie, and major nonbank financial institutions during the peak of the financial crisis in 2008 and 2009.

How the crisis increased banking concentration

Source: Two Areas of Present Concern: the Economic Outlook and the Pathology of Too-Big-to-Fail (With Reference to Errol Flynn, Johnny Mercer, Gary Stern and Voltaire) Remarks before the Senior Delegates’ Roundtable of the Fixed Income Forum, Carlsbad, California, July 23, 2009

(Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas)

"...The financial crisis has had some important consequences for the structure of the banking industry—indeed, the financial industry as a whole. We saw the investment banking model largely disappear as some of the major players—Goldman Sachs and Morgan Stanley—converted to bank holding companies, while some others—Merrill Lynch, Bear Stearns and Lehman Brothers—are no longer with us. The restructurings that have taken place have certainly altered the shape of the U.S. banking industry.

A major concern of mine is that all the crisis-related acquisitions we have seen may further consolidate financial assets and power into the hands of a few large organizations, leading ultimately to reduced competition and a less diverse and efficient financial sector. The massive government assistance recently provided to large banks may be artificially tilting the competitive balance in favor of large institutions.

For example, each of the four largest commercial banking organizations, and others as well, was provided with substantial government assistance during the crisis—all, at least implicitly, in the name of the too-big-to-fail doctrine. As a group, the total asset base of the four has grown 30 percent since June 2007.[6] In contrast, industry assets outside the four have grown a smaller 12 percent.

That growth reflects acquisitions. Bank of America’s assets grew 51 percent from June 2007 to March 2009, assisted in no small part by its acquisitions of Countrywide Financial and Merrill. Wells Fargo’s asset base grew 138 percent, thanks mainly to its acquisition of Wachovia. J.P. Morgan Chase acquired both Bear Stearns and Washington Mutual and grew 43 percent.

The only institution among the top four that did not grow is Citigroup, whose assets declined almost 20 percent. And here’s an interesting observation: Rough estimates suggest the top four institutions together would have shrunk—not just Citigroup—if not for the acquisitions just mentioned. Taking out the acquired assets, the current top four likely would have shrunk 7 percent as a group over the period in question.

The acquisitions of troubled banks have worked to perpetuate size concentration in the banking industry. The top four currently control 44 percent of industry assets. If we simply take away from the top four the assets they recently acquired, they would have “only” 30 percent of the industry’s asset base.

In using acquisitions to resolve the crisis, we may have unwittingly perpetuated one of its root causes—the too-big-to-fail doctrine.

Thoughtful critics will point out that too-big-to-fail is economically perverse: There is something inherently anticapitalistic when you have a system that allows banks, their shareholders and creditors to profit when things go well but leaves the taxpayer holding the bag when things turn sour.

The economist Allan Meltzer likes to say that “capitalism without failure is like religion without sin: It doesn’t work.” In order to have a financial system that remains the fountainhead of credit and the wherewithal for business men and women to bring forth new ideas and products and create employment, we must have a dynamic system that rewards winners rather than coddles losers, that incentivizes prudent behavior and harshly penalizes imprudent behavior.

My colleague Gary Stern—the outgoing president of the Minneapolis Fed who literally wrote the book on TBTF (too big to fail)—recently gave a speech that pulled no punches on this front. He said (a) “it is striking that most of the losses suffered to date during the financial crisis have been at the largest institutions operating in the country,” (b) the problem of too-big-to-fail was “not … addressed effectively by the FDICIA legislation of 1991 [Federal Deposit Insurance Corporation Improvement Act]” and (c) “creditors of such [large] complex financial institutions expected, on the basis of relatively well-established precedents and on an understanding of policymakers’ motivations, protection if failure threatened.”[7] Thus incentivized, management of these institutions took excessive risk, and the market underpriced that risk. And it follows in President Stern’s mind, as it does in mine, that unless incentives are focused upon in seeking to cure the problem of TBTF, we will not only fail to address this most troublesome pathology but may make it worse.

Stern argues that the Treasury proposal now on the table to correct the problem “fails” in regard to corralling incentives for managers of large institutions to repeat the errors for which the public has recently paid so dearly. Here is his punch line: “I would describe the Treasury plan … as ‘status quo plus’—[with] more capital, more liquidity, better supervision, [and] far-reaching resolution authority for the largest institutions. [But] [t]here is little reason to think that these steps will … succeed in reining in TBTF effectively over time because they do not change the incentives which create the problem. In fact,’’ Stern concludes, “there is nothing in the Treasury proposal designed to put creditors of large, systemically important financial institutions at risk of loss. … [T]he Treasury proposal … leaves the financial system considerably more vulnerable …”[8]

As we grapple with TBTF and with the overall regulatory treatment of so-called Tier 1 institutions, we are going to have to bear Gary Stern’s criticism in mind. The only way to ensure a robust financial system is to enforce a system that marries risk-taking to consequences and see to it that the consequences for mismanagement are loss of managerial positions and the capital of shareholders and creditors, including uninsured depositors, rather than a second chance that only further concentrates financial power.

This is important—not only to ensure a more efficient economic system but to better facilitate the implementation of monetary policy. The extent and duration of the extraordinary steps taken by those of us at the Fed are complicated by the prolonged existence of financial institutions that fall into this troublesome category.

Banks that are too big to fail exacerbate business and credit cycles. In the good times, these institutions use excessive leverage and their cost-of-funds advantage to grow more rapidly than smaller banks. Expansionary monetary policy is then given a boost as these institutions grow at eye-popping rates.

But what happens when financial conditions worsen? Too-big-to-fail banks must de-lever, shrinking their asset books and, in general, swimming against the tide of easier monetary policy. As the weak capital position of these institutions becomes widely recognized, they find it difficult and costly to raise funds. A weakened financial system with several of these banks will induce a flight to quality, increasing credit spreads and interest rates at a time when the Fed is attempting to do just the opposite. This slows economic growth, reducing asset values and overall wealth as credit availability deteriorates further. An adverse-feedback loop is created, working in direct opposition to the policy efforts of the central bank.

The existence of financial institutions that are too big to fail dramatically impacts the transmission mechanisms of monetary policy. The blockages they create—in credit markets and on balance sheets throughout the economy—compound our travails by making it more difficult to get the timing and dosage of monetary policy “right.” They reduce the effectiveness of our traditional tools, introducing a need for special liquidity and credit facilities that are difficult to unwind.

I know my opinions on this subject will hardly endear me to the largest financial institutions. On his death bed, Voltaire (who was neither a Hollywood lyricist nor a movie actor nor the president of the Federal Reserve Bank of Minneapolis) was asked to renounce the devil. He is said to have replied that this was no time for making new enemies. Some think that during this time of crisis and with financial and economic recovery still so tenuous, it is not the right time to think about proposals that make the perfect the enemy of the good. I disagree. I believe we need to “think long,” as the Californian George Shultz likes to say, and the current policy prescription for treatment of TBTF is a bit shortsighted or, at best, necessary but not sufficient. If we want to avoid a repeat of what has just happened over the past 18 months, we need to exorcise the notion that an institution is too big to fail and remove all incentives for any institution to risk infecting the health of the financial system. If we make some enemies in the process, so be it. The object is to get it right."

Speech notes

  • 1. In Fed We Trust: Ben Bernanke’s War on the Great Panic,” by David Wessel, New York: Crown Business, 2009, p. 130.
  • 2. See note 1, p. 124.
  • 3. “Back from the Abyss: Now What?” May 15, 2009, and “Remarks Before the Washington Association of Money Managers,” May 28, 2009.
  • 4. Federal Reserve Statistical Release H.4.1, July 16, 2009.
  • 5. “The Fed’s Exit Strategy,” by Ben Bernanke, Wall Street Journal, July 21, 2009, p. A15.
  • 6. Data on banking assets include the nonbank subsidiaries of bank holding companies, not just the bank subsidiaries. In this way, while these numbers do not encompass the financial sector as a whole, they are broader than just bank numbers alone. The statistics presented here make the point that crisis-related consolidation worked to perpetuate concentration of assets and financial power.
  • 7. “Remarks to the Helena Business Leaders,” Federal Reserve Bank of Minneapolis President Gary H. Stern, July 9, 2009.
  • 8. See note 7.

Bernanke on banking concentration

"...As the crisis has shown, one of the greatest threats to the diversity and efficiency of our financial system is the pernicious problem of financial institutions that are deemed “too big to fail.” I will spend some time today discussing the efforts the Federal Reserve and other policymakers are making to put an end to the too-big-to-fail problem and thus help foster effective competition in financial services. I also want to speak today about the links between your institutions and mine. The Federal Reserve has always had a special relationship with community banks. As we turn from crisis management to supporting the economic recovery, that relationship will become more important than ever.

Toward a More Competitive, Efficient, and Innovative Financial System

The United States has a financial system that is remarkably multifaceted and diverse. Some countries rely heavily on a few large banks to provide credit and financial services; our system, in contrast, includes financial institutions of all sizes, with a wide range of charters and missions. We also rely more than any other country on an array of specialized financial markets to allocate credit and help diversify risks. Our system is complex, but I think that for the most part its variety is an important strength. We have many, many ways to connect borrowers and savers in the United States, and directing saving to the most productive channels is an essential prerequisite to a successful economy.

That said, for the financial system to do its job well, it must be an impartial and efficient arbiter of credit flows. In a market economy, that result is best achieved through open competition on a level playing field, a framework that provides choices to consumers and borrowers and gives the most innovative and efficient firms the chance to succeed and grow. Unfortunately, our financial system today falls substantially short of that competitive ideal.

Among the most serious and most insidious barriers to competition in financial services is the too-big-to-fail problem. Like all of you, I remember well the frightening weeks in the fall of 2008, when the failure or near-failure of several large, complex, and interconnected firms shook the financial markets and our economy to their foundations.

Extraordinary efforts by the Federal Reserve, the Treasury, the Federal Deposit Insurance Corporation (FDIC), and other agencies, together with similar actions by our counterparts in other countries, narrowly averted a global financial collapse. Even with those extraordinary actions, the economic costs of the crisis have been very severe; but I have little doubt that, had the global financial system disintegrated, the effects on asset values, credit availability, and confidence would have resulted in a far deeper and longer-lasting economic contraction. It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.

The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too-big-to-fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm’s business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.

Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses. Our economy is not static, and our banking system should not be static either.

In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too-big-to-fail problem once and for all. But how can that be done? Some proposals have been made to limit the scope and activities of financial institutions, and I think a number of those ideas are worth careful consideration.

Certainly, supervisors should be empowered to limit the involvement of firms in inappropriately risky activities. But even if such proposals are implemented, our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope. The unavoidable challenge is to make sure that size, complexity, and interconnectedness do not insulate such firms from market discipline, potentially making them ticking time bombs inside our financial system.

To address the too-big-to-fail problem, the Federal Reserve favors a three-part approach. First, we and our colleagues at other supervisory agencies must continue to develop and implement significantly tougher rules and oversight that serve to reduce the risks that large, complex firms present to the financial system. Events of the past several years clearly demonstrate that all large, complex financial institutions, not just bank holding companies, must be subject to strong regulation and consolidated supervision.

Moreover, the crisis has shown that supervisors must take account of potential risks to the financial system as a whole, and not just those to individual firms in isolation.

Implementing supervision in a way that seeks to identify systemic risks as well as risks to individual institutions is a difficult challenge, but the fact is that the traditional approach of focusing narrowly on individual firms did not succeed in preventing this crisis and likely would not succeed in the future. Consequently, we at the Federal Reserve have been working with international colleagues to require that the most systemically critical firms increase their holdings of capital and liquidity and improve their risk management; and we are overhauling our supervisory framework for the largest institutions, both to improve the effectiveness of consolidated supervision and to incorporate in our oversight a more comprehensive, systemic perspective.

Stiglitz on banking concentration

"Joseph Stiglitz, the Nobel Prize- winning economist, said the U.S. has failed to fix the underlying problems of its banking system after the credit crunch and the collapse of Lehman Brothers Holdings Inc.

“In the U.S. and many other countries, the too-big-to-fail banks have become even bigger,” Stiglitz said in an interview yesterday in Paris. “The problems are worse than they were in 2007 before the crisis.”

Stiglitz’s views echo those of former Federal Reserve Chairman Paul Volcker, who has advised President Barack Obama’s administration to curtail the size of banks, and Bank of Israel Governor Stanley Fischer, who suggested last month that governments may want to discourage financial institutions from growing “excessively.”

A year after the demise of Lehman forced the Treasury Department to spend billions to shore up the financial system, Bank of America Corp.’s assets have grown and Citigroup Inc. remains intact. In the U.K., Lloyds Banking Group Plc, 43 percent owned by the government, has taken over the activities of HBOS Plc, and in France BNP Paribas SA now owns the Belgian and Luxembourg banking assets of insurer Fortis.

While Obama wants to name some banks as “systemically important” and subject them to stricter oversight, his plan wouldn’t force them to shrink or simplify their structure.

Stiglitz said the U.S. government is wary of challenging the financial industry because it is politically difficult, and that he hopes the Group of 20 leaders will cajole the U.S. into tougher action.

“We aren’t doing anything significant so far, and the banks are pushing back,” said Stiglitz, a Columbia University professor. “The leaders of the G-20 will make some small steps forward, given the power of the banks” and “any step forward is a move in the right direction.”

G-20 leaders gather Sept. 24-25 in Pittsburgh and will consider ways of improving regulation of financial markets and in particular how to set tighter limits on remuneration for market operators. Under pressure from France and Germany, G-20 finance ministers earlier this month reached a preliminary accord that included proposals to reduce bonuses and linking compensation more closely to long-term performance.

“It’s an outrage,” especially “in the U.S. where we poured so much money into the banks,” Stiglitz said. “The administration seems very reluctant to do what is necessary. Yes they’ll do something, the question is: Will they do as much as required?”

Measuring the cost of the "implicit guarantee"

"...We can’t be sure who the specific members of this [TBTF] club are — regulators simply say they know ’em when they see ’em. But this much is certain: They’ve seen a lot of them lately.

As taxpayers, we obviously can’t rely on lawmakers to address the risks we face from the ever-expanding corporate safety net thrown under teetering behemoths. But because we are footing the bills for these rescues — and will do so again if more crises occur — don’t you agree that we should know what these implied federal guarantees will cost us?

If the government won’t reduce the size of the safety net, and it has shown no appetite for doing so, it should at least tell us the price tag.

Marvin Phaup, a research scholar at George Washington University who examines federal budgeting, is one who is urging such an assessment. An expert on government guarantees, his wholly sensible view is that it is dangerous for possible bailout costs to remain unmeasured and, of course, unrecognized in the budget. “If we are extending the safety net, extending the implied guarantee to the debts of a lot of other financial institutions, and we know those guarantees are valuable and costly, then we ought to start budgeting for it,” Mr. Phaup said in an interview. “We can’t reduce the costs of these subsidies if we can’t recognize them.”

Mr. Phaup has the bona fides to opine on this topic. He was the researcher at the Congressional Budget Office in 1996 who undertook the first efforts to assign a value to the implied federal guarantee backing Fannie and Freddie. When he prognosticated on the matter, the bailouts of those two hobbled entities were more than a decade away, but his C.B.O. report quantified the billions in benefits that the mortgage finance companies reaped each year from their implicit government backstop.

In 1995, the report said, the value of the companies’ government subsidy totaled $6.5 billion; this amount largely reflected lower borrowing costs at the companies, a result of views held by investors that Fannie’s and Freddie’s obligations had Uncle Sam’s backing.

THE C.B.O. report enraged Fannie and Freddie because it also showed how much of that financial benefit — fully one-third — the companies kept for themselves, their managers and their stockholders. Mr. Phaup’s analysis showed that, counter to the companies’ claims, Fannie and Freddie did not pass along all the benefits to homeowners in the form of lower mortgage rates.

Moreover, who actually believed in 1996 that the government would ever have to bail out Fannie and Freddie? Perish the thought and shame on silly researchers like Mr. Phaup for even considering such possibilities.

Fast-forward to today, and the government guarantees for Fannie and Freddie have become painfully explicit. While it’s unclear how much their rescues will cost taxpayers, last Christmas Eve the government removed the $400 billion cap on the amount of assistance it was willing to provide the companies in emergency aid through 2012.

Today’s implied guarantees extend well beyond Fannie and Freddie. But owning up to future obligations associated with government backing is something that lawmakers are likely to fight vigorously. (Consider Social Security.)

But ignoring such obligations doesn’t make them go away. And getting a handle on their possible cost is a worthy exercise, for several reasons..."

TBTF "free money borrowing"

Analysis and discussion with Niall Ferguson of Harvard University; Banks still too big to fall and free borrowing helps banks.

What is TBTF worth I?

PERHAPS you've noticed that being too-big-to-fail comes with some fairly significant benefits. Notably, you can't be allowed to fail. That implicit government backing should also allow TBTF firms to borrow more cheaply than smaller firms, boosting profits. It should therefore be the case that acquisitions which put banks over the TBTF threshold contain some information about the value of attaining that status.

That's what Philadelphia Fed economists Elijah Brewer and Julapa Jagtiani thought, and they set out to test their hypothesis. Zubin Jelvah summarises their findings (PDF):

Using data from bank mergers between 1991 and 2004, Brewer and Jagtiani estimate that banks paid a combined TBFT premium of $14 billion for acquisitions that put them above the TBTF threshold (which they define in three different ways: assets above $100 billion, market cap above $20 billion, or being one of the 11 largest banks in the United States). This premium accounted for around 50 percent of the overall merger premium paid by the acquirers. And while many mergers (whether in the financial sector or not) have been knocked for not living up to the promised hype, Brewer and Jagtiani find that markets perceived the creation of new mega-banks as value enhancing.

One drawback to Brewer and Jagtiani's estimate is that they couldn't account for benefits that accrued to bondholders and uninsured depositors (rather than to management alone), meaning that the $14 billion figure is in all likelihood a lower bound for the true subsidies big banks receive.

This is worth thinking about as finance and economic experts debate just what to target—size, leverage, or something else—to limit future bail-outs. I have previously argued that leverage or interconnectedness were as important as sheer size, but this would seem to indicate that banks believe sheer bigness is enough to get the government's support.

What is TBTF worth II?

I was not going to bother to comment further, but after hearing pundit after pundit attack Obama for the bank levy and Glass Steagal 'lite', after banks allegedly paid their dues... I just couldn't take it anymore.

Yes! Obama has made a lot of policy errors in dealing with the banks. Yes! I believe he has not solved the problems, but has chased the symptoms. The separation of prop trading from deposit banking IS the RIGHT thing to do. In addition, the banks have not come anywhere NEAR repaying their debt to the government. Not even close.

Yes, some of the banks repaid TARP, with interest and warrants. Okay. The investment big banks (that were still in existence) were offered expedited financial holding company (bank) charters. That is why they didn't fail, at least in part.

So, running down the list, the banks paid back TARP. That's a +, but....

  1. What was the value for bank charter, to get cheap access to the Fed's funds? did they pay back this value yet? No!
  2. How about the payment of interest on the banks' excess reserves at the Fed. Have the banks repaid that yet? No!
  3. The Fed and the Treasury have purchased hundreds of billions of dollars of Agency debt, Agency mortgage-backed securities (MBS) and related securities through Treasury purchase programs. Have the banks paid back the capital behind those purchases yet? No!
  4. How about the Term Auction Facility? Has the capital behind the benefits of that program been paid back? No!
  5. Then there is the Primary Dealer Credit Facility (PDCF), has this been paid back? No!
  6. Do you remember the Term Asset-Backed Securities Loan Facility (TALF)? Have the funds behind that been paid back? No!
  7. What about the PPIP? No!
  8. Hey, there's the Foreign Exchange Swap programs (the currency swap lines, that saved not only our banks but out banks facing counterparties who were short on dollars), has that been paid back? No!
  9. There's the Commercial Paper Funding Facility (CPFF), have the funds behind that been paid back? No!
  10. Most importantly, the opportunity cost of ZIRP, which hurts those who do not speculate (or have not speculated) with near free money! How do you pay that back to grandma and her .017% CDs?

How do you repay the synthetic bid that the Fed has created under MBS that has rescued the banks from balance sheet purgatory (for now)? How about the accounting fantasy football game that was authorized by FASB last year that has lost fundamental investors who actually count vast sums of money? Then there is those FDIC bond guarantees... Oops, I went way past 1 reasons, didn't I?

I can rant on, but if I haven't driven the point home by now, I probably never will. So as you read about Goldman's earnings beat on weaker revenue, consider the advantages that they have, that they didn't pay back, that smaller businesses such mine simply don't have access to.

FSB: Guidance to assess systemic importance

International Monetary Fund, Bank for International Settlements, Financial Stability Board Report to G20 Finance Ministers and Governors

Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments:

Initial Considerations The attached report and background paper respond to a request made by the G20 Leaders in April 2009 to develop guidance for national authorities to assess the systemic importance of financial institutions, markets and instruments. The report outlines conceptual and analytical approaches to the assessment of systemic importance and discusses a possible form for general guidelines.

The report recognizes that current knowledge and concerns about moral hazard limit the extent to which very precise guidance can be developed. Assessments of systemic importance will necessarily involve a high degree of judgment, they will likely be time-varying and state-dependent, and they will reflect the purpose of the assessment. The report does not pre-judge the policy actions to which such assessments could be an input.

The report suggests that the guidelines could take the form of high level principles that would be sufficiently flexible to apply to a broad range of countries and circumstances, and it outlines the possible coverage of such guidelines. A set of such high level principles appropriate for a variety of policy uses could be developed, further, by the IMF, BIS and FSB, taking account of experience with the application of the conceptual and analytical approaches described here.

There are a number of policy issues where an assessment of systemic importance would be useful. One critical issue is the ongoing work to reduce the moral hazard posed by systemically important institutions. The FSB and the international standard setters are developing measures that can be taken to reduce the systemic risks these institutions pose, and the attached papers will provide a useful conceptual and analytical framework to inform policy discussions. A second area is the work to address information gaps that were exposed by the recent crisis (the subject of a separate report to the G20 from IMF staff and the FSB Secretariat), where assessments of systemic importance can help to inform data collection needs. A third area is in helping to identify sources of financial sector risk that could have serious macroeconomic consequences. We will keep you informed on our respective future policy work in these important areas.

Financial Stability Forum sets up "supervisory colleges" for TBTFs

II. International cooperation

Supervisory colleges

Supervisory colleges have now been established for more than thirty large complex financial institutions identified by the Financial Stability Forum (FSF) as needing college arrangements, the final few needed having been established in recent months.

The FSB committed to review the college arrangements in 2009 and to work to ensure consistency in approaches. Over the summer, the Basel Committee on Banking Supervision (BCBS) conducted a detailed survey of college arrangements and practices in the banking sector, at the request of the FSB. The FSB carried out a stocktaking of existing college arrangements in the insurance sector, working with the International Association of Insurance Supervisors (IAIS).

The surveys highlighted a number of issues for further consideration by the FSB and standard setters:

  • Some of the colleges are broader in membership than may be most effective. A balance needs to be found between the desire for an inclusive membership and the need to keep the college effective. There is a need to consider whether colleges with broader membership function effectively, so that issues are targeted at those sets of regulators best placed to take these forward, making appropriate use of core, regional and wider college arrangements.
  • There is scope for information exchange within colleges to be made more effective, including through the establishment of a wide range of communication channels.
  • There is a need to consider ways by which adequate exchange of information with host supervisors that are not members of the (core) college membership can be achieved while avoiding unnecessary burdens.
  • A successfully operating college should change the way that national supervisors work, as it should give them a better understanding of the risk profile of the firm and avoid duplication of efforts. While the existing college arrangements have entailed some joint work or the sharing of tasks among supervisors, colleges are not undertaking joint work among their member supervisors as a matter of course.
  • Supervisory colleges could play a useful role as a conduit for sharing information in crisis-management work. While there is no single approach to ensuring that information is shared effectively in a crisis, good practices on the role of colleges in assisting cross-border crisis management should be developed.

Drawing on the results of the stocktaking, and recognising the need to maintain flexibility in designing college structures, the FSB will explore the scope for capturing good practices in the operation of colleges and information sharing in a protocol, drawing on the work of the BCBS to develop guidelines on the efficient establishment and operation of colleges, as well as the work of the IAIS to develop guidance on the use of supervisory colleges for insurance groups.

FSA on high level policy approaches to TBTF

3.7 This section, therefore, pulls together all the different strands of the debate and the different policy options which have been proposed. It considers in turn:

  1. Defining the problem: ‘failure’ in non-systemic and systemically important firms.
  2. The historic approach before the crisis in the UK and globally.
  3. Coverage of these issues in The Turner Review DP and subsequent UK and international policy developments.
  4. The definition of systemic importance: how can it be measured?
  5. Alternative policy approaches: reducing the probability of failure or reducing the consequences of failure.
  6. The cross-border dimension and ‘too-big-to-rescue’: more global or more national approaches?
  7. Reducing inter-connectedness in wholesale trading: central counterparties and improved risk management.
  8. ‘Utility banking’ versus ‘casino banking’: narrow bank options.
  9. Current FSA policy stance and issues for debate.

Tarullo on Fed TBTF proposals

"...A regulatory response for the too-big-to-fail problem would enhance the safety and soundness of large financial institutions and thereby reduce the likelihood of severe financial distress that could raise the prospect of systemic effects. Such a response consists of three elements.

First, the shortcomings of the regulations that failed to protect the stability of the firms and the financial system need to be rectified. Regulatory capital requirements can balance the incentive to excessive risk-taking that may arise when there is believed to be government support for a firm, or at least some of its liabilities. There is little doubt that capital levels prior to the crisis were insufficient to serve their functions as an adequate constraint on leverage and a buffer against loss. The Federal Reserve has worked with other U.S. and foreign supervisors to strengthen capital, liquidity, and risk-management requirements for banking organizations. In particular, higher capital requirements for trading activities and securitization exposures have already been agreed. Work continues on improving the quality of capital and counteracting the procyclical tendencies of important areas of financial regulation, such as capital and accounting standards.

These regulatory changes are surely a necessary part of a response to the too-big-to-fail problem, but there is good reason to doubt that they are sufficient. Generally applicable capital and other regulatory requirements do not take account of the specifically systemic consequences of the failure of a large institution. It is for this reason that many have proposed a second kind of regulatory response--a special charge, possibly a special capital requirement, based on the systemic importance of a firm. Ideally, this requirement would be calibrated so as to begin to bite gradually as a firm’s systemic importance increased, so as to avoid the need for identifying which firms are considered too-big-to-fail and, thereby, perhaps increasing moral hazard.

While very appealing in concept, developing an appropriate metric for such a requirement is not an easy exercise. There is much attention being devoted to this effort--within the U.S. banking agencies, in international fora, and among academics--but at this moment there is no specific proposal that has gathered a critical mass of support.

A third regulatory change is in some respects the most obvious and straightforward: Any firm whose failure could have serious systemic consequences ought to be subject to regulatory requirements such as those I have just described. At present, these apply only to firms that own a commercial bank--a regulatory gap that became painfully evident last year as systemic problems arose from the activities of other firms. Although the five large, "free-standing" investment banks of early 2008 have subsequently either converted to bank holding company status or ceased operations as independent firms, action by Congress is needed to ensure that other firms posing such a risk--now or in the future-- can be brought within the perimeter of regulation.

This regulatory agenda has much to be said for it and should, I believe, be vigorously pursued. But I doubt that rules directed at the conduct of financial firms will be an adequate response to the too-big-to-fail problem. In the first place, there is some danger that simply piling on a series of administrative reforms and restrictions intended to constrain the behavior of firms would have unnecessarily adverse consequences for the availability of credit on risk-sensible terms for consumers and businesses alike. The interaction of regulatory changes needs to be thought through. Also, the financial crisis should itself inject a considerable dose of humility into regulators’ assessment of the efficacy of even well-considered regulations. Rules directed at the behavior of large firms must be complemented with reforms directed at the behavior of their investors and counterparties..."

Choices in financial regulation I

"...In this crisis, the official response has been to expand the scale and scope of public sector support, initially in the form of Federal Reserve lending, and later in the form of capital assistance for financial firms from the U.S. Treasury and guarantees on newly issued debt by the Federal Deposit Insurance Corporation.

This response came in an attempt to make sound choices in an ever-deteriorating sequence of situations. At each moment of crisis, it is hard to argue with the proposition that losses to the creditors of a large, interconnected financial firm pose significant risks to the financial system and the broader economy.

But the cumulative effect of these actions has been to solidify long-held beliefs by many market participants that large, interconnected financial firms will be viewed by policymakers as "too-big-to-fail," or at least too big to fail in a way that imposes substantial losses on creditors.

These beliefs have evolved over a number of decades, through a series of actions that included the bailout of Continental Illinois National Bank and Trust in 1984, regulatory forbearance for banks that became undercapitalized from losses related to the debt of less developed countries in the 1980s, and the private sector rescue of Long Term Capital Management orchestrated by the New York Fed in 1998.

While this last action involved no public sector funding, it clearly signaled an official concern for the disruption that could follow an outright default.3

The result is an environment in which there is both broad agreement on the need for stronger regulatory oversight of financial markets and institutions and widespread dissatisfaction with the scale of the official financial support the crisis has seemed to require. So we seem to face the same fundamental choice that my predecessor described 16 years ago: more regulation or more market discipline? The leading proposals before Congress concentrate almost exclusively on expanding government protection and regulation, but I believe we would be better off placing greater reliance on market-based incentives for prudent risk management.

What Financial Markets Do

Financial markets are fundamental to the way an economy allocates its scarce resources to their most productive uses. The markets and institutions that make up our financial system collect the savings of households and businesses and reallocate those funds to other households and businesses – as well as governments – who seek to finance additional current consumption or investment spending.

The possible uses of funds are many and diverse, varying both in expected outcomes and in risk. The conventional view of a market mechanism is that competition among alternative users of funds, through prices offered and bid, will tend to allocate those resources to their best uses, taking into account both risk and return.

In doing so, markets also bring together the disparate knowledge of various market participants, none of which has a complete picture of the array of available investment opportunities.

These two functions of financial markets – allocating resources and aggregating information – are clearly interdependent.

After all, how can you distribute funds to their best uses without knowing something about the relative risks and rewards of various alternatives?

Financial markets do not perform these functions perfectly. Limits to the information held by individual market participants and incompleteness in the range of financial instruments and markets available for trading risks and rewards mean that markets may not achieve the same results that could be realized by the – hypothetical – omniscient central decision maker in economists' models.

Indeed, such informational limits appear to motivate many types of financial intermediaries and a host of other financial market features. But these same imperfections mean that it is likely to be very hard to find a way to systematically improve on market outcomes, because the same informational limits are likely to apply to the real world policymaker, who lacks the theoretical omniscience of the economist's fictional decision maker.

What Financial Safety Nets Do

Government guarantees of private debt – either explicit or implicit – can have profound effects on debtors' and creditors' incentives to appropriately price and manage risk exposures. These effects are likely to have been particularly acute for the large institutions that were at the heart of this crisis and viewed as too big to fail.4

Their creditors will see their own risks as at least partially reduced by the explicit or implicit government guarantees, and will therefore require less of a risk premium and impose fewer covenant restrictions than they otherwise would. Inexpensive debt financing will encourage an institution to seek greater leverage than it otherwise would, and increased leverage, in turn, makes an institution less averse to taking large risks, other things being equal.

Measuring the effects of the safety net on incentives for risk management is difficult. But measuring the safety net itself is possible. Research by Richmond Fed economists showed that in 1999 about 27 percent of all of the liabilities of firms in the U.S. financial sector were explicitly guaranteed by the federal government.5

By their estimate, another 18 percent enjoyed at least some implicit support, or were likely to be perceived by markets to have such support, so a total of 45 percent of financial sector liabilities had at least implicit government backing.

This was a conservative estimate of implicit guarantees, consisting basically of the government-sponsored enterprises and the uninsured deposits of the largest banks.

In the course of the current crisis, explicit guarantee programs have grown, for instance through the expansion of deposit insurance. An estimate of the implicit safety net guarantees would also no doubt be larger today, as we have seen protection temporarily extended to nondeposit creditors of banks and other financial institutions. So it seems likely that a substantially larger fraction of the financial sector is now operating under the effects of the safety net.

The scale and scope of the financial safety net should be matched by the scale and scope of the regulatory and supervisory regime surrounding financial institutions.

The central role of prudential regulation is to constrain and prevent the excessive risk-taking that would otherwise be induced by the incentive effects of safety net support.

Capital regulations, for example, limit leverage, and supervisory oversight of financial institutions' risk management systems seeks to assure that senior management – and supervisors – understand the risks the institution takes.

The dramatic recent expansion of government support for financial institutions and markets has enlarged the safety net to well beyond the scope of the previous regulatory regime.

If no corrective action is taken to close that gap, the next economic expansion will likely see more excessive risk-taking and end with more firms in financial distress.

The Origins of the Crisis, Revisited

The basic choice we face in restructuring financial regulation is this: To what extent do we expand regulatory constraints to catch up with an expanded safety net and to what extent do we limit the safety net and rely on market incentives? Based on the experience of the last several years, it may be tempting to conclude that a market-based approach has failed and needs to be replaced by tougher regulatory constraints. This, after all, is the popular narrative which portrays the financial crisis as the inevitable aftermath of an inherent tendency towards excessive risk-taking in unregulated financial markets.

But market incentives have been seriously distorted for some time by beliefs about the financial safety net.

In fact, I believe that the incentive effects of the financial safety net added to the vulnerability of financial institutions and contributed significantly to the housing boom and subsequent bust.6

Perceptions that some financial institutions were too-big-to-fail, including the housing-related government sponsored enterprises, reduced their cost of debt and capital and helped spur innovations in securitization and risk distribution which ultimately posed challenges for our regulatory apparatus.

Those institutions enjoyed an artificial advantage in providing guarantees and backstop liquidity support through off-balance-sheet entities, support which would prove most valuable during times of financial distress, when ostensibly off-balance-sheet assets would "boomerang" back onto bank balance sheets. And during the financial turbulence of the housing bust, the prospect of official support blunted the incentives of many financial firms and their creditors to protect themselves against the possibility of "runs" or "panics" that might lead to disruptive failures.2

Two Paths

The extent to which decades of policy precedents led to growing expectations of official support in instances of financial distress suggests a view of this financial crisis that is different from the popular narrative. Successive crises elicited broadened support, but this case-by-case evolution makes it hard to characterize just what limits, if any, there are to safety net support to large financial firms at any one time.

The resulting uncertainty itself can be a source of volatility when financial distress looms as market participants are forced to speculate on the likelihood of a rescue. That uncertainty can create further pressure to bail out a distressed firm to avoid disappointing expectations and a sharp pullback by investors from other firms. The result has been an ever growing expectation of support, a dynamic which my former colleague Marvin Goodfriend and I wrote about 10 years ago.8

One key, therefore, to improving financial market performance is greater clarity about safety net policy. We should seek to identify and articulate clear and credible limits to our willingness to shield private creditors from loss.

This necessarily means taking steps to limit discretion in the midst of financial disturbances. To understand why, put yourself in the position of a creditor of a large financial institution and ask yourself the following question: "If, in spite of the government's best regulatory efforts, this institution finds itself on the brink of a financial crisis, threatening the failure of an array of institutions, how are the authorities likely to respond?" If the answer involves expanded protection to that institution, then market discipline has been weakened. And if the nature of the authorities' response has not been made clear ahead of time, then financial market volatility is likely to be greater as well.

This is a relevant question because regulatory restraint on bank risk taking can never be perfect.

Regulators, who as I said lack the omniscience of the economic theorist, cannot prevent the failure of all large complex financial institutions, nor should they attempt to do so.

In the presence of a substantial safety net, competition will drive firms to seek innovative ways to take on leveraged risks and to bypass regulatory constraints.

A market participant might then reasonably assume that regulators will successfully manage routine risks, while novel, nonroutine risks that result from financial innovations are likely to be more difficult to manage and afforded special protection.

And it is nonroutine, innovation-related risks that have been the source of past crises and will likely be the source of future crises.

The case for the discretionary use of public funds rests on the desire to head off the costly effects that might result from a large firm's unassisted failure. Many have pointed to the market turmoil that followed the Lehman Brothers failure last September as an example of such effects.

But the general distress on the days and weeks that followed was a response to many things. The news of Lehman's failure alone, quite apart from how that failure was resolved, was clearly relevant to creditors of other financial institutions with mortgage-related exposures.

That information was going to be revealed in any case, and in fact one would actually want it absorbed quickly in the prices of other financial assets for the financial system to function effectively.

Another important component in the market response to Lehman was undoubtedly the unexpected nature of the government's treatment of Lehman, given the actions that had come before in the period since the summer of 2007.

Market participants marked down the probability they attached to future rescues, and no doubt further revised those probabilities (both up and down) many times in the days that followed.

The argument for scaling back the safety net is not an argument for safety net uncertainty.

Rather, it is an argument that we should both create expectations about the limits of assistance and take actions that validate those expectations.

The real lesson from Lehman, in my view, is that officials should make a clear commitment about what institutions they will not support."

Choices in regulation II

"...After the deepest recession since the 1930s, which has seen the world’s largest economy shrink 3.9 percent since the second quarter of last year, and more than $1.6 trillion in worldwide losses and writedowns by banks and insurers, President Barack Obama decided on a policy of containment rather than a structural transformation.

His proposal for revamping the way the U.S. monitors and controls banks doesn’t include taking apart institutions, supported by taxpayer loans, that have grown in scope and size since Lehman imploded. The biggest, Charlotte, North Carolina- based Bank of America, had $2.25 trillion in assets as of June, 31 percent more than a year earlier, and about 12 percent of all U.S. deposits.

Creating Bedlam

Instead, the Obama plan would label Bank of America, New York-based Citigroup and others as “systemically important.” It would subject them to capital and liquidity requirements and stricter oversight, relying on the same regulators who didn’t understand the consequences of a Lehman failure. And while companies could be dismantled if they got into trouble, they, their creditors and shareholders could also be bailed out with taxpayer money, according to the plan.

The chief architects, Geithner, 48, and National Economic Council Director Lawrence H. Summers, 54, say they don’t think it would be practical to outlaw banks of a certain size or limit trading activities by deposit-taking banks, according to people familiar with their thinking. They said the two men, who declined to be interviewed, and others on Obama’s team believe the lines are too fuzzy between banking and investing products and that forcing the divestiture of units and assets would create bedlam...

...“Most reform proposals acknowledge, perhaps with some consternation, that systemically important institutions are likely to be with us into the indefinite future,” said Daniel K. Tarullo, a member of the Fed’s board of governors, in an interview. “The proposed reforms are oriented toward forcing those institutions to internalize more of the risks they create and thus making it less likely they will create problems for the system as a whole.”

A Financial Services Oversight Council -- made up of the heads of the FDIC, the Securities and Exchange Commission, the Commodity Futures Trading Commission and other agencies -- would advise the Fed on potential threats.

The Treasury would be able to take over and wind down financial institutions with an authority modeled on powers held by the FDIC, which guarantees deposits and can close and sell failing banks under its jurisdiction. A Consumer Financial Protection Agency could restrict what it viewed as unsuitable products for Americans..."

Choices in regulation III

We will supervise our major financial firms more intensively and, after the financial system has had time to emerge from the recent crisis, we will hold these firms to tougher safety and soundness standards than other firms, including tougher capital and liquidity requirements. We will require that supervision of these firms include effective oversight of the parent company and all of its subsidiaries. And we will require a new kind of supervision of these firms – one designed to protect overall financial stability and not just the solvency of individual companies.

Our plan for stricter supervision and regulation of the major financial firms will have several powerful effects. It will force these firms to pay an appropriate regulatory price for the risks that their failure or distress could impose on the broader financial system. It will offset the perceived government support enjoyed by these firms, which should substantially reduce any competitive advantage they have due to the market's assumption that they would receive assistance in the event of failure. In sum, our proposals will provide positive incentives for these firms to shrink and to reduce their leverage, complexity, and interconnectedness. In addition, more conservative supervision and regulation of our major financial firms should reduce the probability that they will fail and therefore the likelihood that they will pose a threat to the financial system.

Third, we must reduce moral hazard, improve market discipline, and limit the risk that the taxpayer has to bear in the next crisis and the costs they shoulder. Our plan will do this in a number of ways.

We will require our major financial firms to prepare and regularly update a credible plan for their rapid resolution in the event of severe financial distress. We will require supervisors to carefully evaluate the plan on an ongoing basis. This requirement will create incentives for a firm to better monitor and simplify its organizational structure and would better prepare the government – as well as the firm's investors, creditors, and counterparties – in the event the firm collapsed.

In addition, as Lehman's collapse showed, existing bankruptcy arrangements are often ill-suited for dealing with the insolvency of large financial institutions. We will give the government the capacity, as it has now for banks and thrifts, to dismember or unwind major financial firms in an orderly fashion with less collateral damage to the system. Simultaneously, we will enhance market discipline by enabling the government to manage the resolution of troubled firms in a manner that imposes losses on firms' stakeholders.

It is imperative that we minimize the risks that taxpayers pay the price of a future rescue of the financial sector. Therefore, any losses that might be incurred by the government in its efforts to resolve failing financial firms will be recouped through assessments on other large financial firms.

Crucially under our proposals, there will be no fixed list of Tier 1 FHCs, and identification of a firm as a Tier 1 FHC will not convey a government subsidy – it will be no guarantee of extraordinary governmental assistance in the event of financial distress. To the contrary; it will be a guarantee of substantially stricter supervision and regulation by the government – an intensity of government oversight that will serve as a strong disincentive for firms to become too big, complex, leveraged, and interconnected.

We understand the need to coordinate regulation of major financial firms internationally to prevent geographic regulatory arbitrage. Financial firms, markets, and transactions have never been more globally mobile. The G-20 Leaders have acknowledged that we must raise safety and soundness standards for all major financial firms to consistently high levels, and we look forward to working with our colleagues around the world to do just that.

Calculating the cost of TBTF

Barclays has done a number on European banks. On Tuesday morning it has published a full 351 pages worth of research, in six separate notes, as it started coverage of the sector with the team it poached from Citigroup.

FT Alphaville will be picking out some highlights — to begin with, the notion of ‘Too Big Too Fail’ (TBTF).

Here’s what the BarCap analysts, led by Simon Samuels and Mike Harrison, say:

Banks have not always been this big. Indeed, as recently as 1990 none of the top 25 banks in the world boasted a balance sheet larger than their host country’s GDP (indeed, bar UBS, they were all less than one quarter of their host country GDP). By 2007 – on the eve of the financial crisis – this had totally changed . . .

Total balance sheet is not the only measure of size, but it is an important one. Eventually, if banks get too big, then national governments – as the ultimate guarantor of the system – lack credibility. This was exactly what happened to Iceland in 2008, and presumably would have happened to Ireland were it not a Eurozone member. Other measures – such as employment within financial services – show a similar pattern with the proportion of the working population in Europe employed in financial services rising from 10% in 1990 to 15% today. However sliced, banks have got bigger.

“So what?” you might ask. On one level, it is a perfectly reasonably question. It is not that long ago that the prevailing mantra was that bigger banks were safer. Moreover, there was hardly a detectable size-related pattern to the banks that “failed” in this crisis. Universal and narrow banks, large and small banks all ended up being rescued by either their governments or their competitors.

Whilst banks may have got bigger relative to the wider economy, it is not at all clear that bigger banks are more vulnerable. Indeed, to put the point another way – it could be argued that smaller, more narrowly defined institutions are more vulnerable to failure (see later).

That, however, misses the crucial point – namely that an industry that has been forced to rely to an unprecedented extent on its taxpayer base (capital injections for some banks, funding and funding guarantees for all banks) must expect those taxpayers in turn to demand widespread restructuring. The taxpayer cry is simple – “this must never happen again” . . . A number of major economies have either committed and/or distributed a significant percentage of their GDP as part of the rescue of the global banking sector. And it is for that reason that the debate over the cost to the taxpayer of failure – especially for those banks deemed TBTF – has now emerged.

And the TBTF response could take three forms, according to Barclays.

First, you could force banks to get smaller, though the analysts say a simple screening by size would not have predicted bank failures in the recent financial crisis.

Second, you could try to make banks “fail proof” by improving their solvency or liquidity (i.e. boosting their capital or requiring them to hold more liquid assets, be more self-funded, etc.).

Third, you could try to implement some sort of “controlled failure” procedure (the idea of living wills etc.).

Barclays’ biggest point though, is that regulatory proposals will be felt by banks deemed TBTF.

The BarCap analysts have accordingly come up with a list of 20 European banks they think could be considered TBTF by virtue of their size, interconnectedness or just identification by regulators as systemically important.

The results are to the right, click to enlarge.

In addition to identifying those 20 TBTF banks, Barclays also shows the impact of them having to carry additional regulatory capital above the sector average (currently Core Tier 1 of 8 per cent for 2011).

2007-2009 credit crisis

Source: Too Big to Fail? New York Times Week in Review, July 20, 2008

"...So it made for a strange spectacle last weekend as the current Bush administration, which does cast itself in the Reagan mold, hastily prepared a bailout package to offer the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. The reasoning behind this rescue effort — like the reasoning behind the government-induced takeover of Bear Stearns by J. P. Morgan Chase just a month before — sounded no different from that offered in defense of many a bailout in Japan and Europe:

The mortgage giants were too big to be allowed to fail.

Big indeed. Together, Fannie and Freddie own or guarantee nearly half of the nation’s $12 trillion worth of home mortgages. If they collapse, so may the whole system of finance for American housing, threatening a most unfortunate string of events: First, an already plummeting real estate market might crater. Then the banks that have sunk capital into American homes would slip deeper into trouble. And the virus might spread globally.

The central banks of China and Japan are on the hook for hundreds of billions of dollars worth of Fannie’s and Freddie’s bonds — debts they took on assuming that the two companies enjoyed the backing of the American government, argues Brad Setser, an economist at the Council on Foreign Relations.

Commercial banks from South Korea to Sweden hold investments linked to American mortgages. Their losses would mount if American homeowners suddenly couldn’t borrow. The global financial system could find itself short of capital and paralyzed by fear, hobbling economic growth in many lands.

Nobody with a meaningful office in Washington was in the mood for any of that, so the rescue nets were readied. The treasury secretary, Henry Paulson Jr., announced that the government was willing to use taxpayer funds to buy shares in Fannie and Freddie. The chairman of the Federal Reserve, Ben Bernanke, said the central bank would lend them money.

The details were up in the air as the week ended, but some sort of bailout offer was on the table — one that could ultimately cost hundreds of billions of dollars. Whatever the dent to national bravado, or to the free-enterprise ideology, the phrase “too big to fail” suddenly carried an American accent.

“Some institutions really are too big to fail, and that’s the way it is,” said Douglas W. Elmendorf, a former Treasury and Federal Reserve Board economist who is now at the Brookings Institution in Washington. “There are no good options.”

Still, there are ironies. Since World War II, the United States has been the center of global finance, and it has used that position to virtually dictate the conditions under which many other nations — particularly developing countries — can get access to capital. Letting weak companies fail has been high on the list.

Mr. Paulson, who announced the bailout, made his name as chief executive of Goldman Sachs, the Wall Street investment giant, where he pried open new markets to foreign investment. As treasury secretary, he has served as chief proselytizer for American-style capitalism, counseling the tough love of laissez-faire. In particular, he has leaned on China to let the value of its currency float freely, and has criticized its banks for shoveling money to companies favored by the Communist Party in order to limit joblessness and social instability.

All through Japan’s lost decade of the 1990s and afterward, American officials chided Tokyo for its unwillingness to let the forces of creative destruction take down the country’s bloated banks and the zombie companies they nurtured. The best way out of stagnation, Americans counseled, was to let weak companies die, freeing up capital for a new crop of leaner entrants."

Moody’s: Citigroup still ‘too big to fail’

Even though the Obama administration is trying to sell idea that the era of “too big to fail” is over, some in the market still aren’t buying it.

Case in point: Citigroup Inc.

Moody’s on Monday said in its “Weekly Credit Outlook” that the Treasury Department’s planned sale of its 7.7 billion shares of Citigroup this year doesn’t mean the government would remove its implicit support of the company if Citigroup were to fall into trouble again.

“The likelihood of government support remains very high because of Citigroup’s systemic importance to the U.S. and global financial system as a major counterparty, payments and clearing agent, deposit taker, and provider of credit,” Moody’s said. This is important, because Moody’s said it doesn’t see any “”rating implications from the disposition of the government’s 27% stake in the company.” In other words, Citigroup can still continue issuing debt at levels that assume a type of government support.

“Permanent government ownership of shares can be an important factor to consider when evaluating the probability of government support for a bank,” Moody’s said. “However, in our analysis we never assumed that the U.S. government’s stake in Citigroup was permanent. Instead, as noted above, our support assumptions are very high because of Citigroup’s interconnectedness in the global financial system and its systemic importance.”

Moody’s goes on to say that the “greatest threat” to “continued government support for Citigroup and other major U.S. banks is from pending legislative proposals that would allow the government to resolve failing but systemically important financial institutions in a way that imposed losses on bondholders while still minimizing systemic risk.”

This is the bill passed the House of Representatives in December and could soon advance to the Senate floor.

GE likely to remain TBTF

Source: GE shares up after word Capital spin-off unlikely July 30, 2009, Reuters

"General Electric Co (GE.N) shares climbed 5 percent on Thursday after a powerful U.S. lawmaker suggested a planned financial regulatory overhaul would not force the largest U.S. conglomerate to spin off its hefty finance arm.

Goldman Sachs raised its rating on the shares to "buy" on the news.

Bloomberg News reported that U.S. Rep. Barney Frank said in an interview that GE's ownership of GE Capital was "not part of the problem" that caused the financial crisis.

Frank's office could not be reached for immediate comment.

Many investors had feared that the Obama administration's planned overhaul of the system could compel Fairfield, Connecticut-based GE to spin off the finance unit. That business over the past year has become the company's Achilles heel, and GE management was working to downsize it in the face of falling profits.

GE shares rose 58 cents to $12.84 in premarket trading.

"Greater potential for a manageable regulatory outcome should prompt investors to focus on longer-term benefits of economic and credit stabilization to GE shares," Goldman Sachs analyst Terry Darling wrote in a note to clients. Goldman raised its target price on the shares to $15.

Deutsche Bank analyst Nigel Coe took a more measured view on the news, calling it "a modest positive" while noting that "significant risks persist" at GE Capital.

GE officials have repeatedly said they would resist any attempt to force them to spin off GE Capital. Brackett Denniston, the company's general counsel, told a Tuesday investor briefing that he believed "this forced break-up idea is increasingly unlikely to be adopted as part of this total and very complex financial reform package."

Blackrock is world's largest money manager

"In any discussion about winners from the financial crisis, US money manager BlackRock must be the lead contender - having landed a series of lucrative contracts over the past year from US efforts to clear up the financial mess, completed the $13.5bn acquisition of Barclays Global Investors in June and begun planning, as the FT reported last month, to set up its own global trading platform.

As if that’s not enough for what has now become (since the BGI acquisition) the world’s largest money manager with about $3,000bn in assets under management, BlackRock now wants in on the credit-ratings game, according to the Wall Street Journal, which reported on Thursday that BlackRock appears to be in line for a role helping state regulators size up risks in insurers’ investments.

BlackRock is among a handful of firms to have held talks with officials from the National Association of Insurance Commissioners (NAIC) about possibly taking on a slice of work now done by the key credit-ratings agencies, said the Journal, noting that the role, if it comes off, would “mark yet another power shift on Wall Street”. A key group of regulators is expected to vote next week on this proposed switch away from the rating agencies.

The NAIC work, according to the Journal, entails analysing risk in bonds backed by residential mortgages that insurers own. In a revealing explanation, the report adds (emphasis ours):

The NAIC this year grew disappointed with the ratings agencies after their rapid downgrades of once triple-A-rated mortgage bonds left many insurers holding large amounts of “junk.”

"In the wake of the financial crisis, BlackRock has emerged as one of the most valued and influential advisers to the U.S. government. Not only is it the world's largest money manager, with $2.7 trillion in assets under management stemming from its acquisition of Barclays Global Investors (due to close in the fourth quarter), BlackRock also has become a key contractor to the U.S. Treasury department because of the quantitative asset manager's expertise in valuing complex debt instruments.

At the heart of BlackRock's rise to prominence has been its analytics, which are housed in the firm's BlackRock Solutions technology division. The technology organization develops BlackRock's analytics and maintains extensive databases. "Fundamentally, these products are incredibly complicated," says Rob Goldstein, managing director and head of BlackRock Solutions. "We fortunately have the modeling capabilities to look at them from the bottom up."...

...Today BlackRock Solutions employs 1,000 people and has evolved into a global business with clients that span the Americas, Europe, the Middle East, Asia and Australia. It maintains local client service sites in major cities overseas and across the United States. With about $7 trillion in client assets, BlackRock Solutions is the largest securities and portfolio analytics company in the world, according to Goldstein."

Too connected to fail

Source: There are Three, not Two, Kinds of Financial Institutions in the New Resolution Regime Commentary, Joseph R. Mason, Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC

"Recent events at CIT have led observers to focus on the apparent differences between financial institutions deemed too-big-to-fail and others, the “haves” and the “have nots,” respectively. But to make that simple distinction is to ignore broader developments in regulatory policy.

Too-big-to-fail has been around far too long for there to have been so little progress made in resolving large banks.

Favorable de facto developments in resolution policy (what is actually happening, rather than what is supposed to or is proposed to happen) increase hopes of a sensible regulatory approach going forward, albeit one far less radical than the White House’s proposed financial reforms. Finance, however, can never be far removed from politics. Hence, it makes sense to analyze financial policy through the lens of political economy, rather than a narrower view of economic efficiency.

In reality, therefore, there appear to be three sets of institutions separated not by “systemic risk” or even ability to resolve (too-big-to-fail), but by political connectedness:

  • (1) Too-connected-to-ignore;
  • (2) Not-connected-enough-to-matter, and
  • (3) Too-big-to-payout.

I review each of those in turn.

The top set of institutions (not all of them banks) in this hierarchy are those that suffered in the recent crisis but promised to be around afterward to play their part in future lobbying efforts.

Those institutions were able to attract government assistance, whether indirectly through support for their counterparties or directly through special loans or capital assistance in the name of “systemic risk.” Those institutions are demonstrating the benefits and advantages of their status in recent earnings announcements showing stellar financial performance while others continue to suffer. Those are the institutions that Neil Barofsky, Special Inspector General for TARP, is targeting (in a politically palatable approach) for better disclosure.

Those “too-connected-to-ignore” institutions have worked hard to make sure the crisis only temporarily affected their earnings, lobbying hard for protected status and receiving such from a favorable Treasury that cowed a central bank with little real understanding of modern financial arrangements (and that is still trying to catch up from behind the curve).

The next set of institutions is being identified by recent appeals for forbearance or government aid that are repeatedly rebuffed by Administration officials. Those medium- to large-sized institutions receive no special dispensation regardless of their support for or performance in mortgage modification efforts (e.g., First Federal Bank of California), importance to small business lending (e.g., Advanta, CIT), or ability to absorb distressed assets (e.g., private equity and venture capital firms). Those institutions are argued to pose little or no “systemic risk,” and cannot be conceived to be important for economic growth, individually. Equally important, weak banks in this category can be shut down and disposed of within the FDIC’s budget, thereby posing little or no political risk to bank regulators or their funding sources.

The last set of institutions cannot be resolved by traditional means within current FDIC programs, but resolution is keeping apace, nonetheless. It should be clear by now that both Citi and Bank of America have been working closely with the FDIC to restructure their operations in a manner that could result in a combination of asset sales and a core going concern. While it remains to be seen whether the going concerns will be a substantially different size from the current operations, the point, nonetheless, is that both institutions are being taken through a “resolution lite,” a confidential procedural mechanism to stabilize the operations using at least the intent, if not the legal and regulatory rules, of bridge bank mechanisms and influence. Hence, the FDIC continues to develop its large bank resolution techniques, and those still seem to be effective at getting the attention of large diversified bank holding companies, despite Administration rhetoric.

Finance can never be far removed from politics and politics is all about appearances. Hence, it is important to separate de jure regulatory authority from what is actually happening in the crisis. Large weak banks are being resolved, and contrary to the allegations of “too-big-to-fail.” Political influence, however, has (once again) expanded the liberal use of Federal Reserve section 13(3) emergency powers, linking those with similar uncodified Treasury extensions to form a new source of de facto government backstop that is already being critically leveraged by institutions that have proven in the crisis they are “too-connected-to-fail,” albeit politically, not economically, connected."

"Wall Street has become hard to regulate because we’ve allowed it to evolve that way. Credit is vital to any economy beyond the barter stage. As commerce became large scale and more interconnected, bank failures, which were once local affairs, increasingly led to widespread panics that produced considerable harm. As a result, government not only started to provide more safety nets for banks but also supervised them and placed limits on their activities.

It is pretty hard to regulate someone who has a knife at your throat. Since the 1980s, lending has shifted from banks to the capital markets. While many loans do remain with the bank that originated them, in the U.S., what Treasury Secretary Timothy Geithner has called “market-based credit” has become prevalent. Even though a bank initially extends the loan, it is often on-sold through capital markets firms to investors.

That process gives major financial players control over the all-important over-the-counter debt markets. Most of these deals do not trade much once sold, making them ill-suited to shift on to exchanges that would be easier to police. But these over-the-counter markets have, for a host of reasons, strong scale economies and network effects, so absent intervention, it was inevitable that they would become increasingly concentrated, with a comparatively small number of firms becoming dominant.

Add to that the fact that the major financial players have been allowed to create a host of complex products, like customized derivatives and collateralized-debt obligations, which have often been used to evade regulations or to shift risks on to unsuspecting parties. The worst is that some of these products have now become a vital part of the credit infrastructure (if nothing else, the capital markets firms that now control the crucial financial plumbing use them to manage their exposures), making it difficult to rein them in.

Regulators sat on the sidelines as these new complex instruments proliferated, and frankly do not understand them very well. Even if they were somehow able to become as expert as the big financial firms on the level of trade craft, they still lack the data and knowledge to ascertain what the systemwide effects of significant changes in the rules might entail. Given how interconnected financial markets are, and how some efforts to intervene during the crisis produced unexpected, adverse side effects, they worry that efforts to contain risky products and practices could backfire and actually make matters worse."

Not too connected to fail

"...It was against this backdrop that Goldman’s chief financial officer, David Viniar, got on a conference call with reporters last week and said Goldman enjoys no government guarantee. Not even an implicit one, he said.

Viniar’s remarks came after a reporter for the Daily Mail of London, Simon Duke, posed a perfectly reasonable question: “It seems fairly clear that, post-Lehman, that the U.S. Treasury’s not going to let any bulge-bracket firms go under,” Duke began, according to an audio recording of the call. “How can you justify these levels of pay, when you effectively enjoy an implicit guarantee from the U.S. taxpayer?”

The pay Duke was referring to was the $16.7 billion that Goldman has accrued for employee-compensation expenses so far this year. Viniar responded by attacking his question’s premise.

“We’ve heard many people say that, but we certainly don’t operate the company that way,” Viniar said. “We operate as an independent financial institution that stands on our own two feet.” He didn’t stop there.

“If we felt that we had an implicit guarantee, we would not be holding nearly $170 billion of cash on our balance sheet. We would not have reduced our balance sheet by $400 billion.” (Actually, the “cash” figure he cited also included certain securities that Goldman considers to be highly liquid.)

After Duke pressed him further, Viniar turned emphatic. “I don’t believe any of our bondholders think that we have a guarantee, and we don’t think we have a guarantee,” he said..."

Expose management to personal bankruptcy

"... No surprise, then, the perversity of Wall Street's incentives. For rolling the dice, the payoff is potentially immense. For failure, the personal cost -- while regrettable -- is manageable. Senior executives at Lehman Brothers, Citi, AIG and Merrill Lynch, among other stricken institutions, did indeed lose their savings. What they did not necessarily lose is the rest of their net worth. In Brazil -- which learned a thing or two about frenzied finance during its many bouts with hyperinflation -- bank directors, senior bank officers and controlling bank stockholders know that they are personally responsible for the solvency of the institution with which they are associated. Let it fail, and their net worths are frozen for the duration of often-lengthy court proceedings. If worse comes to worse, the responsible and accountable parties can lose their all.

The substitution of collective responsibility for individual responsibility is the fatal story line of modern American finance. Bank shareholders used to bear the cost of failure, even as they enjoyed the fruits of success. If the bank in which shareholders invested went broke, a court-appointed receiver dunned them for money with which to compensate the depositors, among other creditors. This system was in place for 75 years, until the Federal Deposit Insurance Corp. pushed it aside in the early 1930s. One can imagine just how welcome was a receiver's demand for a check from a shareholder who by then ardently wished that he or she had never heard of the bank in which it was his or her misfortune to invest.

Nevertheless, conclude a pair of academics who gave the "double liability system" serious study (Jonathan R. Macey, now of Yale Law School and its School of Management, and Geoffrey P. Miller, now of the New York University School of Law), the system worked reasonably well. "The sums recovered from shareholders under the double-liability system," they wrote in a 1992 Wake Forest Law Review essay, "significantly benefited depositors and other bank creditors, and undoubtedly did much to enhance public confidence in the banking system despite the fact that almost all bank deposits were uninsured."..."

Break up banks

Bernanke: "Regulators should be able to shrink firms"

Federal Reserve Chairman Ben S. Bernanke said regulators should have the power to shrink banks that pose risks to markets, signaling support for proposals in Congress that let the U.S. cut the size of financial companies.

“The supervisors should be allowed by law to insist that the company divest itself or shrink its activities,” Bernanke said today in response to a question after a speech to the Economic Club of New York.

Congress is considering legislation giving government the power to force the breakup of a firm that has become so large that its failure in bankruptcy could threaten the economy. Lawmakers are seeking to avoid ad hoc actions such as last year’s $700 billion bailout of large firms, including New York- based insurer American International Group Inc.

Bernanke said imposing the Glass-Steagall Act, which split investment-banking from lending and deposit-taking, on a case- by-case basis “would not be constructive.” The law was repealed in 1999.

Many firms stumbled by making commercial loans while other lenders were tripped up by engaging in “market-making activities,” Bernanke said. “So the separation of those two things per se would not necessarily lead to stability,” he said.

Representative Ed Perlmutter, a Colorado Democrat, has suggested letting the Fed impose the law as needed.

House Financial Services Committee Chairman Barney Frank has proposed giving the Fed power to reduce a company’s size by forcing the sale and transfer of assets and off-balance-sheet items. Senate Banking Committee Chairman Christopher Dodd’s plan would give that power to a new systemic-risk regulator that includes the Fed.

Dismantling Proposals

Representative Paul Kanjorski, a Pennsylvania Democrat, is planning to amend Frank’s legislation to let regulators dismantle large systemically risky firms. Senator Bernard Sanders, a Vermont independent, unveiled legislation Nov. 6 requiring the Treasury Department to name banks whose collapse could shake the economy and break them up in a year.

Frank, a Massachusetts Democrat, plans to resume committee debate on his systemic-risk legislation this week and has said the House may vote on his overhaul package next month. Dodd, a Connecticut Democrat, said his committee plans to meet the first week of December to begin weighing changes to his proposal before a vote that would send the bill to the full Senate.

The regulatory-overhaul legislation must be passed by the House and Senate and signed by the president to become law.

Summers defends megabanks

President Barack Obama's top economic adviser defended megabanks Thursday, arguing that breaking them up serves no purpose and that a proliferation of smaller banks would instead make the financial system "less stable."

The remarks stand in sharp contrast to those being made by the presidents of at least three regional Federal Reserve banks, one Nobel Prize-winning economist, top bank regulators in Europe, and former Wall Street chieftains, all of whom argue that in order to truly end Too Big To Fail, the U.S. needs to shrink its top financial institutions so that none of them ever again threaten the financial system.

In an interview with "PBS NewsHour", Lawrence H. Summers, director of the White House's National Economic Council, said that breaking up megabanks would hurt the economy.

"Most observers who study -- who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies and hurt the competitiveness of the United States," Summers said in response to a question about whether the U.S. should go further in trying to end Too Big To Fail by limiting the size of banks.

Federal Reserve Bank of Kansas City President Thomas M. Hoenig calls the idea that the U.S. needs megabanks to compete globally a "fantasy."

Tarullo on ineffectiveness of breaking up banks

"Federal Reserve Governor Daniel Tarullo said proposals to separate trading from deposit taking and lending at the biggest banks probably wouldn’t dispel the perception that some firms are too big to fail.

“Some very large institutions have in the past encountered serious difficulties through risky lending alone,” the central bank governor said in remarks yesterday to the Money Marketeers of New York University...

...Tarullo “was lobbying on behalf of the Fed’s positions,” said Ray Stone, a managing director at Stone & McCarthy Research Associates in Princeton, New Jersey, who attended the speech. “It comes down to capital requirements and liquidity requirements. Those are their main tools on the regulatory front.”

Tarullo cited “massive failures” in risk management inside financial firms, and “serious deficiencies” in government regulation as causes of the crisis.

Pose Threat

“As shown by Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to- fail threat,” he said. Lehman Brothers Holdings Inc. collapsed into bankruptcy in September 2008, and Bear Stearns Cos. was merged into JPMorgan Chase & Co. with Fed assistance.

“Too-big-to-fail perceptions weaken normal market disciplinary forces,” Tarullo said. Splitting apart commercial and investment banking activities “would seem unlikely to limit the too-big-to-fail problem to a significant degree.”

Volcker said in Sept. 30 remarks in Gothenburg, Sweden that banks don’t “have any real business in doing a lot of speculative trading.”

Tarullo said in response to an audience question that legislators will need to address the U.S. fiscal imbalance and Fed officials will be watching their efforts with “considerable interest.”

Greenspan on breaking up the TBTF banks

"U.S. regulators should consider breaking up large financial institutions considered “too big to fail,” former Federal Reserve Chairman Alan Greenspan said.

Those banks have an implicit subsidy allowing them to borrow at lower cost because lenders believe the government will always step in to guarantee their obligations. That squeezes out competition and creates a danger to the financial system, Greenspan told the Council on Foreign Relations in New York.

“If they’re too big to fail, they’re too big,” Greenspan said today. “In 1911 we broke up Standard Oil -- so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”

At one point, no bank was considered too big to fail, Greenspan said. That changed after the Treasury Department under then-Secretary Hank Paulson effectively nationalized Fannie Mae and Freddie Mac, and the Treasury and Fed bailed out Bear Stearns Cos. and American International Group Inc.

“It’s going to be very difficult to repair their credibility on that because when push came to shove, they didn’t stand up,” Greenspan said.

Fed officials have suggested imposing a tax or requiring higher capital ratios on larger banks to ensure the firms’ safety and reduce some of the competitive advantage from the implied subsidy. Greenspan said that won’t work.

“I don’t think merely raising the fees or capital on large institutions or taxing them is enough,” Greenspan said. “I think they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”

The former Fed chairman said while “just really arbitrarily breaking down organizations into various different sizes” goes against his philosophical leanings, something must be done to solve the too-big-to-fail issue.

“If you don’t neutralize that, you’re going to get a moribund group of obsolescent institutions which will be a big drain on the savings of the society,” he said.

“Failure is an integral part, a necessary part of a market system,” he said. “If you start focusing on those who should be shrinking, it undermines growing standards of living and can even bring them down.”

Former Citi CEO on separating commercial and investment banking

To the Editor:

Re “Volcker’s Voice, Often Heeded, Fails to Sell a Bank Strategy” (front page, Oct. 21):

As another older banker and one who has experienced both the pre- and post- Glass-Steagall world, I would agree with Paul A. Volcker (and also Mervyn King, governor of the Bank of England) that some kind of separation between institutions that deal primarily in the capital markets and those involved in more traditional deposit-taking and working-capital finance makes sense.

This, in conjunction with more demanding capital requirements, would go a long way toward building a more robust financial sector.

John S. Reed New York, Oct. 21, 2009

The writer is retired chairman of Citigroup.

Financial Times commentary

"In coming up with solutions that address the immediate crisis but fail to tackle dangerous systemic issues, the Group of 20’s emerging ideas on the banking industry bear a striking resemblance to the Americans’ response to the dotcom crash of 2001-02. Back then, the burst bubble exposed biased research and stock price manipulation on Wall Street and dubious accounting practices in US companies. Out came a new set of rules cleaning up the links between research analysts and investment bankers and laying a heavy hand on corporate chief executives.

These measures extinguished the fire but neglected more fundamental problems. By the time the regulations were in place, the investment banks and elements of the corporate sector were already deeply involved in new and even more dangerous practices. We speak, of course, of the derivatives-based leverage of banks’ balance sheets that brought down a range of previously sound institutions, dragged the global economy into recession and ripped up accepted economic theories.

We see exactly the same mistakes being made this time around. If effectively implemented (not the only possible outcome), the G20 finance ministers’ steer towards more and better capital, constraints on leverage and contingency plans for banking failures would help to avoid a repetition of the current crisis. But they are barely sufficient to give the financial services system the kind of radical overhaul it needs.

That would entail tackling a defective business model. Banks are allowed to mix plain vanilla deposit-taking and lending with high-risk investment banking. They are allowed to act for clients on both sides of a trade and take a proprietary turn out of the middle. In capital markets transactions they are able to act for those seeking capital and those providing it. Conflict of interest is embedded and this is unfair on other market users. It is “heads we win, tails you lose” as the banks make off like bandits in the good times and become pious onlookers as the taxpayer foots the bill when it all goes wrong.

Fixing the system requires this business model to be broken up and we would go beyond conventional Glass Steagall type solutions. Activities such as corporate finance, providing advice for investors and proprietary trading should be separated from each other as well as being split off from deposit-taking. This would create smaller, less profitable institutions and solve a number of problems, many of which have been caused by financial institutions over-trading. The system we advocate would restore the balance of economic power towards industries other than finance. It would stem the flow of capital that goes into bankers’ bonuses (a problem that the proposals coming out of G20 seem unlikely to solve) and would rid the world of financial institutions that were too big to be allowed to fail.

Many heavyweight thinkers have dismissed narrow banking (a less radical option than the one we advocate) as, to quote Lord Turner, chairman of the UK’s Financial Services Authority, “not feasible”. They point out that although Northern Rock was not an investment bank and Lehman was not a deposit-taking bank, both failed. This is another example of fighting the last war. The real problems are not the specific causes of the crises of 2008 (banks) or 2001 (dotcom) or 1998 (Long-Term Capital Management) or 1989 (US Savings and Loans), but the enduring power of finance to be socially and economically disruptive.

We do not expect politicians and regulators to restructure the global financial services industry at what is still a critical moment for the economy. But it is regrettable that they appear to have shut the door on even having such a conversation. A starting point, as we have argued before, would be to set up a banking commission informed but not dominated by people from outside the industry. Its remit would be to consider structural change and how the financial services industry can serve the wider social and productive needs of the economy.

This crisis has offended people’s basic notions of fairness. The connection between effort and reward must be proportionate and the playing field needs to be level if we are to secure a fully functioning market economy underpinned by political stability. That is why there is no option but to start the discussion we advocate."

Shadow Banking: What It Is, How it Broke, and How to Fix It

Downsizing can begin with the following set of actions:

  • All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and—more importantly—to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.
  • All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.
  • Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.
  • The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest.
  • In its examination, the FDIC will determine which of these banks is insolvent based on current market values—after netting positions. Those that are insolvent will be resolved. *Resolution will be accomplished with a goal of
    • i) minimizing cost to FDIC and
    • ii) minimizing impacts on the rest of the banking system.

It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.

These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose.

The financial system would emerge with healthier institutions and with much less market concentration.

Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can’t do it, as they do not have the financial resources to meet the potential claims (see AIG). And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behaviour.

As "Credit Insurer of Last Resort" (see Professor Perry Mehrling’s paper inventing this term – pdf), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behaviour of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule – i.e. "lend freely but at a high rate during a crisis"): “Insure freely but at a high premium.”

UK Chancellor Darling says huge banks 'could be broken up'

"The huge financial groups created during last autumn's banking crisis may face being split up in the future, the chancellor Alistair Darling has said.

Mr Darling told the BBC's Politics Show Scotland that RBS and the Lloyds Banking Group may "need to divest themselves" of some of their business.

EU regulations about market domination may force banks into the move, he said.

Mr Darling was speaking exactly a year since three of the UK's biggest banks were bailed out by the government.

In response to the global financial crisis, the UK government nationalised Northern Rock and Bradford and Bingley, and put £37bn of capital into RBS, Lloyds TSB and HBOS.

The taxpayer now owns 43% of Lloyds Banking Group - which took over HBOS - and 70% of RBS.

However, the chancellor told the BBC that the EU's competition commissioner may force the sell-off of some of the banks' empires.

He said: "The new management at RBS have been going through all the books, root and branch, and they've already decided there's some things they had in the business which they don't see as core to what they do and over time they will seek to sell it.

"They key thing is that none of this, even if the European Commission says they've got to do this or that, is not going to happen tomorrow morning.

"The commission have made it quite clear to us that they're looking over a longer period, these discussions are still going on, but it could be over a number of years."

Dutch bank ING voluntarily breaks apart

"PARIS — ING Group, the Dutch financial services company, said Monday that it planned to break up its insurance and banking businesses and raise up to 7.5 billion euros, or $11.3 billion, in a stock issue, after reaching a deal with the government to repay ahead of schedule half the money it received in a bailout last year.

ING was propped up with 10 billion euros in emergency funds from the Dutch government in October 2008, which helped cushion the company’s core Tier One capital, a measure of financial strength, during the global financial crisis. Since then, the company has begun divesting itself of assets in Europe, Asia and North America in an attempt to raise capital and restructure, as well as appease European Union regulators, who are still investigating the Dutch government’s aid to ING under an asset guarantee program the two entered in January.

The group said Monday that it had wrapped up talks with European Union officials that had led to its decision to separate its banking and insurance businesses, seeking to divest the latter over the next four years.

“Negotiations with the European Commission on the restructuring plan have acted as a catalyst to accelerate the strategic decision to completely separate banking and insurance operations,” the company said. “ING will explore all options, including initial public offerings, sales or combinations thereof.”

Jan Hommen, chief executive of ING, said in a statement that “splitting the company is not a decision we took lightly,” as the combination of banking and insurance provided the company with advantages of scale, capital efficiency and earnings from a diversified portfolio of businesses, but he said those benefits had been diminished by the financial crisis.

The company will seek formal approval for the restructuring plan at an extraordinary general meeting of shareholders next month. In keeping with its new direction, the company said it would restructure its management board.

As part of the deal with the European Commission, ING agreed to sell its U.S. Internet banking arm, ING Direct, by 2013. The company anticipates that it will take several years to get out of the business, but said that it regards the operation as “a very strong franchise” and the U.S. market offers potential for growth.

Those divestments, as well as others, will result in a company with about a third less assets by the end of 2013 than it had when the financial crisis struck last autumn, with its balance sheet expected to be reduced by 600 billion euros, the bank said.

All European banks that received state aid during the financial crisis had to submit restructuring plans to the European Union.

Under the new agreement with the Dutch state, ING has until the end of January next year to repurchase shares issued as part of the bailout, which it plans to do using proceeds from the new stock issue, which will be put up for shareholder approval on Nov. 25.

The early repayment allows ING to pay a 15 percent premium on the securities, or up to 950 million euros, rather than a premium of 50 percent under the original terms of the deal, which would have come closer to 2.5 billion euros.

“We appreciate the ongoing support of the Dutch state,” Mr. Hommen said, “but fully recognize that it is in the best interest of all parties that we get back on our own feet as quickly as possible.”

During a conference call, he said the group would likely pay back the rest of the bailout money before the end of 2011.

Further divestments, Mr. Hommen said, as well as profit from operations, would help ING repay the remaining funds it owed.

The company has been shedding assets steadily this year. It said this month that it had agreed to sell its Swiss private banking unit to the wealth manager Julius Baer. It also announced the sale of part of its North American reinsurance operations to Reinsurance Group of America, the American insurer. And in Asia, Oversea-Chinese Banking Corp. of Singapore agreed to buy ING’s private banking assets in the region for nearly $1.5 billion.

ING said in a separate statement on Monday that it expected net profit for the third quarter, from both banking and insurance operations, would come to 750 million euros after divestments and special items.

A 1.3 billion euro charge that ING took for a payment under the government’s asset guarantee program backing about 22 billion euros in risky mortgages will be booked in the fourth quarter, the company said.

ING shares were down 0.63 percent, or 11 cents, to 17.37 euros in late morning trading in Amsterdam."

Impose civil, criminal and administrative sanctions on TBTF managers

Subprime Bailouts and the Predator State, by Steven A. Ramirez, Loyola University of Chicago School of Law, was recently posted on SSRN. Here is the abstract:

Recent bailouts in response to the subprime crisis evince an ad hoc government response that benefited general unsecured creditors and managers within the financial sector, while inflicting great loss upon taxpayers. The bailouts violated notions of the rule of law and sound macroeconomic science.

In fact, the bailouts were followed by restricted lending and capital hoarding. This paper argues that such bailouts should be powerfully discouraged by imposing a legal framework including civil, criminal and administrative sanctions designed to discourage CEOs and other senior managers from flirting with too-big-to-fail status.

Specifically, such managers would face near-automatic termination, discharge of employment agreements, the loss of protections under the Private Securities Litigation Reform Act, civil fines for causing losses to TBTF firms through unsafe and unsound practices, criminal sanctions for recklessly causing a loss to TBTF firms, and the prospect of administratively ordered prudential divestitures of operating units when a regulator identifies a firm as being TBTF.

The goal is to eliminate the attractiveness of TBTF and thereby avert the huge costs implicit in TBTF. This should assure that bailouts are not a function of political power rather than sound economic policy.

Regulatory basis for TBTF

Before 1950, U.S. federal bank regulators had essentially two options for resolving an insolvent institution: closure, with liquidation of assets and payouts for insured depositors, or purchase and assumption, encouraging the acquisition of assets and assumption of liabilities by another firm. A third option was made available by the Federal Deposit Insurance Act of 1950: providing assistance, the power to support an institution through loans or direct federal acquisition of assets, until it could recover from its distress. The statute limited the "assistance" option to cases where "continued operation of the bank is essential to provide adequate banking service." Regulators shunned this third option for many years, fearing that if regionally- or nationally-important banks were thought to be generally immune to liquidation, markets in their shares would be distorted. Thus the assistance option was never employed during the period 1950-1969, and very seldom thereafter.[3] 

Continental Illinois case

The Continental Illinois National Bank and Trust Company experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan business, and loan participations in the energy sector.

Complicating matters further, the bank's funding mix was heavily dependent on large certificates of deposit and foreign money markets, which meant its depositors were more risk-averse than average retail depositors in the US.

The bank held significant participation in highly-speculative oil and gas loans of Oklahoma's Penn Square Bank. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run in early May 1984.

In the first week of the run, the Federal Reserve System permitted the Continental Illinois discount window credits on the order of $3.6 billion.

Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.

The seventh-largest bank in the nation by deposits would very shortly be unable to meet its obligations. Regulators faced a tough decision about how to resolve the matter. Of the three options available, only two were seriously considered. Even banks much smaller than the Continental were deemed unsuitable for resolution by liquidation, owing to the disruptions this would have inevitably caused. The normal course would be to seek a purchaser (and indeed press accounts that such a search was underway contributed to Continental depositors' fears in 1984). However, in the tight-money financial climate of the early 1980s, no purchaser was forthcoming.

Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?

To prevent immediate failure, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while FDIC gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.

In a the United States Senate hearing afterwards, the then Comptroller of the Currency C. T. Conover defended his position by admitting the regulators will not let the largest 11 banks fail (Inquiry Into the Continental Illinois Corp. and Continental National Bank: Hearing Before the Subcommittee on Financial Institutions Supervision, Regulation, and Insurance of the Committee on Banking, Finance, and Urban Affairs, U.S. House of Representatives, 98th Congress, 2nd Session, 18-19 September and 4 October, 98-111).

Regulatory agencies (FDIC, Office of the Comptroller of the Currency, the Federal Reserve System, etc.) feared this may cause widespread financial complications and a major bank run that may easily spread by financial contagion.

The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline, and may have influenced the decisions behind insolvency of the Washington Mutual in 2008.

For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.

FDIC Improvement Act

The Federal Deposit Insurance Corporation Improvement Act was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method.

The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary. [4]

UK systemic risks remain

"...he crisis last year was the worst Britain had faced in peacetime, Darling told the British Broadcasting Corp. last month. The two banks were not “confident they could get to the end of the day,” on Oct. 7, King told the same program.

“You would have had unmitigated panic and a bank run,” said Tom Kirchmaier, a fellow at the London School of Economics. “People would not have been able to buy bread. The cost to the economy would have been catastrophic.”

RBS and HBOS, then in talks to be taken over by Lloyds TSB Group Plc, had more than 35 million business and individual customers with 475 billion pounds of deposits, 22 percent of the U.K. total, held at about 3,250 branches.

“If RBS hadn’t been propped up as it was, in practice it would have been nationalized the following week,” former Bank of England deputy governor John Gieve said in a Bloomberg Television interview. “If RBS, HBOS, Lloyds had gone down, that would have had huge contagious effects throughout the rest of the world.”

The failure of Edinburgh-based RBS and HBOS would have had a domino-effect with customers seeking to take out their deposits from other lenders and causing a wider run on U.K. banks, said Vicky Redwood, an economist at Capital Economics Ltd.

“Trust in the banking system would have completely collapsed” and would have generated civil unrest, said Redwood. “People would have been rushing to take their money out of the other banks and you would have been heading back to the depression era.”

...Even so, the financial sector “is not out of the woods,” Michael Geoghegan, chief executive officer of HSBC Holdings Plc, Europe’s biggest bank, told investors at a conference organized by Bank of America Merrill Lynch on Sept. 29.

British banks have only recognized 40 percent of a likely $604 billion in writedowns from 2007 to 2010, and earnings won’t be sufficient to offset this, the IMF said Sept. 30. A sluggish economy and rising unemployment will add to loan losses, it said.

“Trust has returned, but there is too much trust and people are taking risks blindly,” said LSE’s Kirchmaier. “If you look at the market, people assume it is back to normal, but there are huge risks in the system.”

These remain, according to Simon Maughan, an analyst at MF Global Securities Ltd. in London. Banks have yet to cut debt sufficiently after balance sheets expanded rapidly during the boom, while regulatory demands for increased capital are “cosmetic,” he added.

“The problem was way too much money in the system and a demand for yield,” Maughan said. “Very little has changed” and banks may be laying “the groundwork for the next crisis.”

The banking crisis was the symptom of an unsustainable asset-price boom “that began when western monetary authorities began to believe that inflation was dead,” said David Sayer, head of retail banking at KPMG. Restricting bankers’ bonuses won’t be enough to stop it happening again, he said.

The banking industry is now engaged in “a period of significant transformation and change,” HSBC’s Geoghegan said last month. “These changes in themselves, if not sensibly introduced in a rational and unemotional way, may well trigger a further crisis of confidence at this fragile time,” he said.

Mervyn King, the governor of the Bank of England, called for banks that are "too big to fail" to be cut down to size, as a solution to the problem of banks having taxpayer-funded guarantees for their speculative investment banking activities. "If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure."

However, Alastair Darling disagreed; "Many people talk about how to deal with the big banks – banks so important to the financial system that they cannot be allowed to fail. But the solution is not as simple, as some have suggested, as restricting the size the banks".

A licence to print money: bank profits in Australia

Banks were portrayed as the villains of the global financial crisis; many of the big international banks and their executives were associated with greed and excessive risk-taking. Regulators were obliged to step in with unprecedented rescue packages to save the financial systems in the US, the UK and, to a lesser extent, the major European countries. Australia was also affected but fortunately, the Australian banking system survived relatively unscathed.

There is now a view that Australians were protected from the crisis because of the financial strength and profitability of the banks and that profitable banks provide a range of other benefits to the Australian community. However, this paper puts the view that Australian banks are too profitable and that their excess profits are being made at the expense of the Australian community. The paper estimates the underlying profits of the banks to remove the impact of the global financial crisis but, as the crisis passes, actual profits will again reflect underlying profits.

The estimates in this paper suggest that the big four banks alone make underlying profits of around $35 billion before tax, of which some $20 billion per annum is likely to reflect the banks’ exploitation of their monopoly over the Australian payments system.


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