'Too Big To Fail' Delaying Recovery, Undermining Public Trust

ThernFederal Reserve Bank of Dallas recently published an essay titled Choosing the Road to Prosperity: rnWhy We Must End Too Big to Fail – Now” written by its ExecutivernVice President and Director of Research Harvey Rosenblum.  This is part two of a summary of that essay.  Part one can be found here: Is Fed Endorsing Ending to Too Big to Fail?</p

Whenrnfinancial institutions started to fail and credit froze in 2008 the FederalrnReserve used the customary tools to get the economy moving again, first cuttingrnand keeping the federal funds rate – what banks charge one another forrnovernight loans – close to zero.  Thisrnusually makes short-term credit available at lower rates, driving borrowing byrnconsumers and businesses while pushing up the value of assets thus bolsteringrnbusiness balance sheets and consumer wealth. rnDeclining rates drive down the dollar making U.S. exports cheaper andrnmore attractive overseas as long as other countries don’t also drive downrnrates.  Second, the Fed has injectedrnbillions of dollars into the economy by purchasing long-maturity assets on arnmassive scale, pushing long term rates down as well.  While this reduces the burden on borrowers itrnpunishes savers, especially those who depend on interest payments.</p

Whilerngrowth restarted in mid-2009 it has been tenuous and fragile and stock market gainsrnwhile large have been volatile.  Jobrngrowth has been disappointing with only a third of the jobs lost to thernrecession regained.</p

“Thernsluggish recovery has confounded monetary policy.  Much more modest Fed actions have producedrnmuch stronger results in the past.  Sornwhat’s different now?”  Part of thernanswer is excesses that have not been wrung out of the system including fallingrnhouse prices that continue to drag down the housing market.  “The Too Big to Fail (TBTF) banks remain atrnthe epicenter of the foreclosure mess and the backlog of toxic assets standingrnin the way of a housing revival.” </p

Anotherrnpart of the answer is the monetary policy engine is not hitting on allrncylinders.  Low federal funds rates haven’trndelivered a large expansion of credit because if one part of the economy isn’trnfunctioning properly it degrades the performance of the rest.  Some contributions to recovery such as assetrnvalue and wealth have been weaker than expected partly because burned investorsrnare demanding higher-than-ever compensation for risk.</p

Recoveryrnalso requires well capitalized financial institutions and the machinery ofrnmonetary policy haven’t worked well because of TBTF.  Many of the biggest banks still have balancernsheets clogged with toxic assets while smaller banks are in much better shaperneither because they didn’t make big bets on mortgage-backed securities, derivativesrnand other risky investments or if they did they have already failed.  </p

Injectingrncapital into the system as the Fed did in 2008 was necessary but one downsidernwas a residue of distrust in the government and the banking system and anrnerosion of faith in American capitalism. rnIt showed ordinary workers and consumers a “perverse side of the system”rnwhere they see that normal rules of markets don’t apply to the rich, powerful,rnand well connected.  TBTF violated basicrntenants of a capitalistic system. rnCapitalism requires:</p<ul class="unIndentedList"<liThe freedom tornsucceed and the freedom to fail. Hardrnwork and good decisions should be rewarded; more importantly, bad decisionsrnshould lead to failure.</li<liGovernment tornenforce the rule of law. This requiresrnmaintaining a level playing field. TBTF undermines equal treatment, reinforcingrnthe perception of a system tilted in favor of the rich and powerful.</li<liAccountability. The perception and reality is that virtuallyrnnobody has been punished for their roles in the financial crisis.</li</ul

Therneconomy faces two challenges.  The shortrnterm must focus on repairing the mechanisms so the impacts of monetary policyrnwill travel through the economy faster and with greater force.  In the long term the country must ensure thatrntaxpayers won’t be on the hook for another massive bailout.  Both challenges require dealing with the threatrnposed by TBTF institutions.</p

Therngovernment’s main response to the crisis was the Dodd-Frank Wall Street Reformrnand Consumer Protection Act and its effectiveness will depend on its final rules.  The lack of regulatory certainty has alreadyrnundermined growth and is delaying repair of the lending and financial marketsrnparts of the monetary policy engine.  </p

Policymakersrncan have the most impact with Dodd-Frank by requiring banks to hold morerncapital, “tacking on additional requirements for the big banks that posernsystemic risk, hold the riskiest assets and venture into the more exotic realmsrnof the financial landscape.”  Capitalrncushions should be tied to size, complexity, and business lines and give TBIFrninstitutions more skin the game and restore market discipline.  Small banks didn’t ignite the regulatoryrncrisis and shouldn’t face the same burdens as big banks that follow riskyrnbusiness models.  TBTF banks’ sheer sizernand their presumed guarantee of government help provided a significant edge -rnperhaps at least a percentage point – in the cost of raising funds.  Making them hold more capital will level thernplaying field among banks.</p

Higherrncapital requirements will require the biggest banks to raise equity throughrnstock offerings or by retaining earnings through reduced dividends.  “Banks that clean up their balance sheetsrnwill have a better chance at raising new funds while laggards will find it morerndifficult and may further weaken and need to be broken up, their viable partsrnsold off to competitors.  It is importantrnto redistribute these assets so as to enhance overall competition.”</p

Whilernthe near-zero federal funds rate helped many banks’ capital rebuilding processrnit could be argued that the zero interest rates are taxing savers to pay forrnrecapitalizing those who caused the problem in the first place.</p

Unfortunatelyrnthe sluggish recovery is a cost of the long delay in setting new standards forrncapital.  Given the urgent need tornrestore growth and a healthy job market “the guiding principles for bank capitalrnregulation should be:  codify andrnclarify, quickly.  There is no statutory mandaternto write hundreds of pages of regulations and hundreds more pages of commentaryrnand interpretation.  Millions of jobsrnhang in the balance.”</p

Asrnpart of its strategy to end TBTF, Dodd-Frank expanded the role of regulatorsrnand added new ones, in effect shifting responsibility from the Fed to Treasuryrnand injecting politics into the mix.  Therncurrent remedy for insolvent institutions, i.e. FDIC resolution, works well forrnsmaller banks but TBTF rescues over the last three decades have penalizedrnequity holders while protecting bond holders and bank managers.  Disciplining the management of big banks,rnjust as happens at smaller bank, would reassure a public angry with recklessrnbehavior necessitating government assistance.</p

Thernquestion remains whether the new resolution procedures will work in the nextrncrisis.  Because big banks often followrnparallel practices, odds are that several will get into trouble at the samerntime and this might overwhelm even the most far-reaching regulator scheme.  TBTF might become TMTF – too many to fail -rnas happened in 2008.</p

Arnsecond issue is credibility.  ThernImplicit guarantee imputed to Fannie Mae and Freddie Mac became explicit forrnthem and for big banks when the federal government did indeed come to theirrnrescue.  Words on paper only matter when bankersrnand their creditors actually believe that Dodd-Frank puts government out of thernbailout business although the new law has begun enforcing some marketrndiscipline.   “The credibility of DoddrnFrank’s disavowal of TBTF will remain in question until a big financialrninstitution actually fails and the wreckage is quickly removed so the economyrndoesn’t slow to a halt.  Nothing would dornmore to change the risky behavior of the industry and its creditors.”</p

Thernsurvivors of 2008 have not changed; their corporate cultures remain based onrnshort -term incentives of fees and bonuses, they have the lawyers and money to resistrnfederal regulation and, their significant presence in dozens of states confersrnenormous political clout.</p

ThernDallas Fed has advocated breaking up the nation’s largest banks into smallerrnunits but it won’t be easy.  There arernthorny issues about how to reduce the size of banks; the level of concentrationrndeemed save will be difficult to determine, and the big financial institutionsrnwill dig in to challenge any breakups. rnBut a financial system composed of enough banks to ensure competition inrnfunding businesses and households with none big enough to put the overallrneconomy in jeopardy will give the country a better chance of navigating throughrnfuture financial difficulties and this level playing field will restore faith inrnmarket capitalism.</p

Asrnstated at the beginning, the problems that periodically roil the financialrnsystem are the result of complacency arising from sustained good times, greed</band irresponsibility that run riot without market discipline, the exuberance</bthat overrules common sense, and the complicity of going along with therncrowd.  These are natural to humans andrnwe cannot eliminate them, merely be alert to them.  But concentration in the financial sector isrnnot natural but rather the result of artificial advantages including that somernbanks are TBTF.  Human weakness willrncause market disruptions; big banks backed by government turn them intorndisasters.</p