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Too Big to Fail = Too Powerful to Pay

posted by Art Wilmarth
Scholars and industry analysts are currently debating whether the Dodd-Frank Wall Street Reform and Consumer Protection Act – passed on June 30 by the House and pending before the Senate – represents meaningful reform. On one issue, however, the outcome is already clear. The largest banks have defeated provisions that would require them to make a meaningful contribution toward the huge subsidies they receive as "too big to fail" (TBTF) institutions.

The federal government's rescue of Continental Illinois in 1984 is generally viewed as the beginning of the TBTF policy. Between 1987 and 1991, federal regulators protected uninsured creditors in other large failing banks, including First RepublicBank, MCorp and Bank of New England. Studies have shown that, between 1984 and 2007, the largest banks paid substantially lower rates on their deposits and bonds and operated with significantly lower capital ratios, compared to smaller banks. Yet the biggest banks paid nothing for the TBTF subsidies they received during that period.

The current financial crisis has underscored the enormous advantages enjoyed by big financial conglomerates. The federal government infused $290 billion of capital into the nineteen largest bank holding companies (BHCs) and AIG. The same institutions issued $235 billion of bonds guaranteed by the FDIC. Those capital infusions and bond guarantees were provided on very favorable terms and represented a large transfer of wealth from the federal government to TBTF institutions. Federal regulators confirmed the TBTF status of the nineteen largest BHCs – each with more than $100 billion in assets – by announcing that the federal government would provide any additional capital those institutions needed to pass their stress test in 2009.

Not surprisingly, Standard & Poor's (S&P) subsequently awarded Citigroup a four-notch rating upgrade (from triple-B-minus to single-A) by virtue of its TBTF status. S&P similarly granted Bank of America and Morgan Stanley three-notch upgrades and gave Goldman Sachs a two-notch upgrade. During the first quarter of 2010, banks larger than $100 billion paid average deposit interest rates that were (i) 47 basis points lower than the average rates paid by banks with assets of $10 billion to $100 billion and (ii) 70 basis points lower than the average rates paid by banks smaller than $10 billion.

Thus, events during the past three years have removed any doubt that TBTF subsidies undermine market discipline and distort economic incentives for the largest financial institutions. The primary goal of financial reform should be to shrink those subsidies and force megabanks to internalize the risks and costs of their activities. Unfortunately, due to the big banks' successful lobbying efforts, the Dodd-Frank bill does very little to accomplish that goal.

The House version of the legislation, passed last December, would have established an ex ante (pre-funded) systemic resolution fund with assets of $150 billion. The FDIC would have created that fund by imposing periodic, risk-based assessments on financial companies larger than $50 billion. The fund would have covered the costs of liquidating systemically important financial institutions (SIFIs), which are called "covered financial companies" in the Dodd-Frank bill. While the ex ante fund was too small (given the costs incurred in bailing out SIFIs during the current crisis), it was a significant step in the right direction. The Senate committee bill would have authorized a similar ex ante resolution fund (though capped at $50 billion). Wall Street targeted the ex ante fund as its top priority for removal from the Senate bill, and the proposal was defeated on the Senate floor after furious lobbying by the largest banks. During the deliberations of the conference committee, Representative Luis Gutierrez and other House conferees voted to revive the ex ante resolution fund. However, Wall Street lobbyists made sure that the provision stayed out of the conference bill.

The House ex ante fund proposal would have significantly reduced TBTF subsidies by forcing the largest financial institutions to pay premiums to cover the estimated future costs of resolving failed SIFIs. To further reduce those subsidies, Congress should repeal the "systemic risk exception" that currently allows the FDIC to use funds from the Deposit Insurance Fund (DIF) to protect uninsured creditors of TBTF banks. A repeal of the "systemic risk exception" would help to ensure that resolutions of SIFIs are kept strictly separate from the DIF's mission to protect bank depositors. In sharp contrast to the House proposal for an ex ante fund, Title II of the Dodd-Frank bill ensures that the federal government will be forced to make bridge loans to cover the costs of future liquidations of SIFIs. Title II authorizes the FDIC to borrow from the Treasury Department to pay the costs of such liquidations, and to recover such costs by making ex post assessments on large financial companies. However, during a severe crisis, TBTF institutions typically do not have enough resources to pay immediate assessments to cover the costs of liquidating their failed peers. Megabanks are frequently exposed to highly correlated losses during a major crisis because they pursued similar high-risk strategies during the boom that led to the crisis.

Consequently, even surviving megabanks usually suffer heavy losses and cannot pay large assessments until long after the crisis is over. Even if surviving megabanks finally repay the costs of a future crisis after several years, the public and the financial markets will rightly view Treasury bridge loans as de facto TBTF subsidies.

Moreover, without an ex ante resolution fund, the most aggressive SIFIs will effectively shift the costs of their risk-taking to their more prudent peers. The most reckless institutions will be the most likely to fail, and their creditors will receive protection even though the failed institutions paid nothing to cover their future resolution costs. In this regard, nobody thinks that a post-funded DIF would be adequate to protect depositors. (Just ask Northern Rock's depositors, who had no faith in the U.K.'s post-funded deposit insurance scheme and therefore ran on their bank until they received a blanket guarantee from the U.K. government.) In fact, the current crisis has demonstrated the grave shortcomings of nonexistent or underfunded deposit insurance systems. Given the clear superiority of an ex ante, adequately funded DIF, Congress should have established an ex ante resolution fund for SIFIs. Wall Street made sure that didn't happen.

But Wall Street didn't stop there. After the ex ante fund was defeated, the House-Senate conferees needed to find a way to pay for the $19 billion estimated net cost of the Dodd-Frank bill during 2011-2020. The Congressional Budget Office (CBO) explained that most of this estimated net cost would result from projected expenditures for resolving failed SIFIs over that ten-year period. To offset that gap, the conferees approved a $19 billion fee, which would be assessed against BHCs larger than $50 billion and hedge funds larger than $10 billion. Wall Street's political machine quickly swung into action. Urged on by lobbyists for major financial institutions, key Republican Senators denounced the $19 billion fee as a "bank tax" and threatened to withhold their votes for the conference bill. Senator Dodd and Representative Frank felt obliged to reconvene the conference committee in order to remove the $19 billion fee. To achieve the required cost savings, the conferees (i) reduced the maximum size of the Troubled Asset Relief Program (TARP) from $700 billion to $475 billion, and (ii) required the FDIC to impose assessments on banks with more than $10 billion in assets in order to increase the required DIF reserve ratio to 1.35% by 2020.

The conferees' new approach covers the estimated net cost of future SIFI liquidations by (1) taking advantage of TARP repayments that otherwise would have been used to reduce the federal budget deficit, and (2) requiring banks larger than $10 billion to pay about $8 billion in additional deposit insurance assessments. Some seventy banks with assets of $10 billion to $50 billion will be forced to help pay those assessments, even though those banks (i) did not originate the subprime loans and related structured-finance securities that precipitated the financial crisis, and (ii) are highly unlikely ever to be treated as SIFIs. The largest banks – which will presumptively qualify for SIFI treatment – will end up paying only a fraction of the CBO's estimated net cost for the new SIFI resolution process.

Thus, the big Wall Street banks have once again proven their political clout. Despite their presumed status as political pariahs, members of the TBTF club have retained most of their existing privileges and have also avoided any significant payment for the subsidies they continue to receive. Between 1998 and 2009, the financial services industry and its real estate allies spent more than $6 billion on political contributions and lobbying expenses. We must conclude, however grudgingly, that Wall Street has received an excellent return on its political investment.


Thanks for the post, Professor. Are you or any colleagues you know of currently trying to analyze the likely impact of the supposed restrictions on banks' proprietary trading/derivative activities?

Three years ago, $19 billion (or even $150 billion) didn't seem like chump change, but with tens of trillions in notional still floating around out there, unwinding is still pretty scary if multiple SIFIs go down at once. Along those lines, I'm hearing that zero is likely to be done to rein in leverage levels.

Given my druthers, I'd rather see random drug testing at the munitions plant than a bevvy of state-of-the-art fire trucks and EMS crews on stand-by down the street. You know -- the whole "ounce of prevention" thing.

I'm wondering how "capital" is defined, e.g., can that 3% be levered up 30 times? Will regulators accept banks' internal VAR modeling a la Goldman? And at what level of company detail will they be required to produce VAR estimates? And will the regulators be able to send in auditors who know what the hell VAR is?

"Don't worry; we're fully hedged."


Three things are needed to flesh out one's understanding of this issue. First, recognition that small banks are backed by many of the same or similar federal guarantees yet are exempt from many regulations that apply to big banks. So it is not a black and white issue that it is only big banks that are somehow free riding. Second, the fisc is always invested in the economy to the extent of the effective tax rate, and thus has independent incentive to prop up the economy. Last, this argument and other distributional arguments that some high net worth segment is not fully recompensing the fisc for some federal benefit overlook the broader reality that such high net worth segment has usually been paying directly or indirectly numerous taxes for many years to fund other people's subsidies and programs that benefit other segments, so that if one looks at a long term flow of funds between such segment and the federal fisc, the claim of unfairness about a specific program is weakened.

@MT: bit of a wordy way of saying you believe in trickle-down, isn't it?

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