Fixing the Too Big to Fail Dilemma

The call to break up banks deemed “Too Big to Fail” (TBTF) is one you’d expect from the likes of Christopher Dodd, Barney Frank, and even Occupy Wall Street-but when you have folks like conservative columnist George Will, the hawkish President of the Dallas Federal Reserve Bank Richard Fisher, and former Citigroup CEO Sandy Weil echoing these sentiments,then maybe it’s time to listen up.

Enter Congressman John Campbell, Chairman of the Financial Services Subcommittee on Monetary Policy and Trade, who just last week introduced the Systemic Risk Mitigation Act, a bill aimed at eliminating the TBTF problem. While the California Republican’s bill doesn’t go as far as saying big banks need to be torn apart, it does intend to shrink TBTF banks by requiring them to hold more capital. The idea is to get big banks to shrink their balance sheets, putting taxpayers at less of a risk in event of a failure.

Campbell’s bill would require banks with more than $50 billion in assets to hold a capital buffer in the form of long-term bonds, which must total at least 15 percent of the bank’s total assets. Investors in these bonds would be prohibited from receiving a government bailout if the bank holding them were to fail. The bill would also use new credit default swaps on the long-term bonds as a measure of the banks stability. If the rates on the swaps rise too fast the banks could be subject to stress test and could even be placed into receivership by the federal government. The bill also seeks to repeal the ban on proprietary trading with customer deposits known as the Volcker Rule from the Dodd-Frank Act, but Campbell concedes that repealing the Volcker Rule is not a “core element” of the bill.

The bill is problematic in the sense that it puts banks like JP Morgan and Bank of America, which individually have over $2 trillion in assets, in the same category and subject to the same rules as a bank, like Salt Lake City based Zions Bank, which has just over $50 billion in assets. The 15 percent capital cushion is also a completely arbitrary amount. On top of that, banks would still have to comply with the Basel III capital requirements that Dodd-Frank seeks to implement as well. It’s double whammy of capital requirements which the big boys with over a trillion dollars in assets may be able bear, but it wouldn’t be as easy for banks closer to the $50 billion threshold.

Perhaps the better line of delineation between big and small is $250 billion. This is more along the lines of the 12 U.S. Banks that Richard Fisher identifiedback in January as candidates for TBTF status. Together, these 12 banks hold 69 percent of total industry assets, but only account for .2 percent of all U.S. Banks.

But the spirit of the bill is fine, right? Not only does it aim to lower systemic risk and taxpayer risk, but it also seeks to level the playing field between small community banks and the larger megabanks. This is the point at which you would normally lose any support from free marketeer’s on the conservative and libertarian side of the spectrum. Why is it governments role to “level the playing field” between the big banks and their smaller competitors? They would argue that if the free market didn’t want big banks, there wouldn’t be big banks and that it’s not the role of Washington to interfere in the way private enterprise conducts business. Washington coming in and trying to break up the big banks could easily be regarded as just as an intrusive form of regulation as the Dodd-Frank Act was.

But what more conservatives and libertarians are starting to realize is that it’s not the free market that keeps these behemoth banks big; it’s crony capitalism.

TBTF banks inherently receive a hidden subsidy just because of the fact they are too big to fail. With very few exceptions, precedent has shown that if a large bank or even a large corporation (like General Motors) is on the verge of failure Washington will stop it from happening if the institutions failure might trigger a chain reaction of failures and widespread economic devastation. This precedent has allowed TBTF banks to obtain lower borrowing costs than its smaller competitors who don’t have the advantage of having the TBTF designation. Far from being any sort of scarlet letter, the TBTF designation has become a source of immense benefit for the big banks which the Dodd-Frank act does nothing to address. The academic literature on the benefits TBTF institutions receive as a result of simply being TBTF is extensive, and places the amount in subsidies received by the biggest banks between $30-$60 billion a year (less so in the years before the financial crisis).

When it was on the verge of failure Lehman Brothers was able to obtain a substantial amount of short-term credit from the Reserve Primary Fund, a large money market mutual fund, in what some economists like Arnold Kling view as nothing more than “a bet that the government would engineer a bailout.” This loan is an advantage that would simply not have been available to a failing community or regional bank at the time, or even now. It’s an advantage that the big banks would not be able to receive themselves on the free market without the TBTF bailout precedent that Washington has already set.

In a recent paper, University of Minnesota Professors John H. Boyd and Amanda Heitz find that their calculation indicate that “the cost to the economy as a whole due to increased systemic risk is of an order of magnitude larger than the potential benefits due to any economies of scale when banks are allowed to be large.” So what the facts are building up to is a situation in which being a big bank is not necessarily a net benefit for the economy, and part of the reason these banks can be so big is because they are supported by the Federal Government in more ways than one (we won’t even get into the revolving door cronyism between SEC officials and TBTF banks over the last 10 years, which has led to numerous exemptions and favorable regulations).

In a sense though Congressman Campbell’s proposal, or any variation of it is really a second best option to privatizing the FDIC, which would not only get taxpayers completely off the hook but it would also allow the free market to determine what the best ways are to go about regulating and insuring big banks. Another option would be to allow banks to opt-out of the FDIC system, and obtain private insurance elsewhere, where they would be subject to different private regulations that may be less stringent than the federal governments, but taxpayers wouldn’t be on the hook if they were to fail. But privatizing the FDIC system simply isn’t politically feasible and unrealistic at this point. Although if you can get Occupiers and George Will to agree on something, then maybe anything is possible.