On Ending Too-Big-to-Fail

too big to failWhen a failing financial company is so systemically important that it must either be bailed out or cause economic catastrophe, it is said to be “too-big-to-fail.”  In recent years, there has been much debate about whether the Dodd-Frank legislation passed in the wake of the 2007 to 2009 financial crisis ended too big to fail.  Last week, during his press conference following the release of the most recent FOMC statement, Ben Bernanke had the following to say regarding the topic:

“I don’t think too-big-to-fail is solved . . . It’s not something we can just forget about.  It may take some time, but too-big-to-fail was a major part of the source of the crisis, and we will not have successfully responded to the crisis if we don’t address that problem successfully.”

I agree with Bernanke that too-big-to-fail has not been solved.  In fact, I think it can be argued that the problem of too-big-to-fail is actually a bigger one now than it was prior to the aforementioned financial crisis.  To help illustrate the fact that too-big-to-fail still lives with us today, the January 2013 PBS special, “The Untouchables,” is quite instructive.  In that special, PBS interviewed Lanny Breuer, then Assistant Attorney General of the Criminal Division of the Department of Justice.  He was asked about comments he made in a September 2012 speech to the New York Bar Association in which he referenced being kept up at night worrying about the consequences of bringing a case against a large global institution.  In response, Mr. Breuer had this to say:

“But in any given case, I think I and prosecutors around the country, being responsible, should speak to regulators, should speak to experts, because if I bring a case against institution A, and as a result of bringing that case, there’s some huge economic effect—if it creates a ripple effect so that suddenly counterparties and other financial institutions or other companies that had nothing to do with this are affected badly—it’s a factor we need to know and understand.”

If the Department of Justice can’t even bring a case against a too-big-to-fail financial institution without considering the possible consequences from a broader economic perspective (irrespective of the merits of the case itself), it is quite clear that too-big-to-fail is alive and well.

In order to one day convince the investing community that too-big-to-fail has been solved, it will likely take real proof for investors to believe the global financial system can survive the winding down of one of its largest banks.  In other words, talk is cheap.  If those in power ever want to convince most investors and the public at large that too-big-to-fail is a thing of the past, they’ll have to show us.  How might they show us?  Two ways come to mind: Either break up the world’s systemically important financial institutions into small enough pieces that everyone can plainly see the risks have been mitigated, or don’t provide a bailout the next time one of them is on the verge of failing.

I know that Bernanke, in his press conference last week, mentioned capital and liquidity requirements as being two ways to help solve the too-big-to-fail problem.  But I think policy makers will be hard-pressed to convince most people that too-big-to-fail is no more until we see how a large financial institution on the brink of failure is actually dealt with and the ramifications thereof.  Or, as previously mentioned, the current systemically important financial institutions could be broken up in such a way that it is plainly obvious that too-big-to-fail will not be a problem in the future.  I’m not holding my breath waiting for that to happen.

When discussing systemically important financial institutions, which banks in particular am I referring to?  

The Financial Stability Board (FSB) was established in order “to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies.”  The United States has three representatives on the Financial Stability Board: the Board of Governors of the Federal Reserve System, the U.S. Securities and Exchange Commission, and the U.S. Department of the Treasury.  Each year, beginning in 2011, the Financial Stability Board publishes a list of “global systemically important banks” (G-SIBs).  As of November 2012, that list includes 28 banks from around the world, eight of which are from the United States.  The U.S. banks on the list are Citigroup, JPMorgan Chase, Bank of America, Bank of New York Mellon, Goldman Sachs, Morgan Stanley, State Street, and Wells Fargo.

As previously mentioned, Bernanke stated in his recent press conference that “we will not have successfully responded to the crisis if we don’t address [too-big-to-fail] successfully.”  While policy makers may think they will succeed at increasing capital and liquidity requirements by enough to avoid the future failure of a G-SIB, or that they may be able to play around with the holding and operating companies of G-SIBs in a way that will temper too-big-to-fail, I think readers should also be open to another possibility.

In the future, it is not out of the question that policy makers, due to political considerations, may decide to yield to public pressure not to bail out another large bank and instead allow one of the aforementioned eight financial institutions to become a sacrificial lamb.  This would be done in an attempt to prove to the public that too-big-to-fail is no more.  We will all have our own opinions about which bank that would be and whether or not that is something even worth considering.  I currently own the bonds of five of the eight U.S. G-SIBs and would own seven of them except for the fact that the market never offered me what I thought was adequate yields on two.  You will notice that I am not naming the one I suspect would be the sacrificial lamb during the next financial crisis if the political and financial landscapes ever got to that point.  I will only say that I take size, complexity, roles and responsibilities in the financial system, and political connections into account when deciding which too-big-to-fail’s bonds to buy and which to avoid.

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