Have we finally fixed the 'too big to fail' problem?
Last night the Senate approved a major financial reform bill almost a year in the making. A few hours before the vote, the president hailed the legislation, which he said ensures that “the American people will never again be asked to foot the bill for Wall Street’s mistakes.” He elaborated:
There will be no more taxpayer-funded bailouts--period. If a large financial institution should ever fail, we will have the tools to wind it down without endangering the broader economy. And there will be new rules to prevent financial institutions from becoming “too big to fail” in the first place, so that we don’t have another AIG.
But is this really true? Does the financial reform bill really solve the problem of “too big to fail”? The answer is: “Sorta,” but not quite in the way the bill’s supporters suggest.
The gist of the administration’s attack on the too-big-to-fail (TBTF) problem is a provision known as “resolution authority.” Under the status quo, the government basically has two choices for dealing with a major financial firm on the brink of collapse: It can get out of the way and hope for the best, as it did to disastrous effect with Lehman Brothers. Or the Federal Reserve can float the company a massive loan, as in the case of AIG.
The idea behind resolution authority is to avoid these lousy choices. Under the new law, the government would be able seize the wobbly firm, fire its executives, and fund its operations until it could sell them off in pieces. The proceeds from these sales would pay the government back; whatever was left would go to bondholders, who would presumably suffer some losses. The shareholders—the people who own common stock—would get wiped out entirely. (If the proceeds weren’t enough to repay the government, it would recoup the rest by levying a fee on the industry.) This is basically a scaled up (and stretched out) version of the way the FDIC handles smaller-bank failures.
Long story short, resolution authority is unquestionably an improvement over the status quo. The biggest reason is that the prospect of losses for bondholders mitigates the most pernicious consequence of TBTF: moral hazard. That is, because people who lend money to megabanks assume the government will make them whole if the bank collapses, the lenders have little incentive to rein in excessive risk-taking by the bank’s managers. In fact, they actually encourage it by under-pricing their loans. The threat of being “resolved” by the government should change that calculus.
That’s how it’s supposed to work, in any case. In practice, there are a number of complications. For one thing, it’s not clear that bondholders actually will suffer losses in the end, at least not all or even most of them. The government isn’t likely to impose losses when it first takes over a failing megabank because doing so in the middle of a financial crisis—and you're almost by definition in a crisis if a megabank is failing—risks accelerating the panic. (Investors might refuse to roll over their loans to other troubled companies for fear of suffering similar losses.) And if the government waits to impose losses until it’s done liquidating the company—a process that could stretch for years—the short-term bondholders will have long since taken their money and run.* So, at the very least, the people who lend short-term may count on being bailed out, which encourages companies to fund themselves with short-term debt, which is the least stable form of funding.
And there are other potential problems. First, the new law only extends to U.S. companies, while most megabanks have an international footing. It’s not clear what happens to the overseas operations of American companies while their U.S. assets are in receivership. In the case of AIG, the Fed loan kept the overseas affiliates solvent. But Congress is on the verge of explicitly preventing the Fed from extending such a loan in the future. The upshot could be chaos. For example, U.S. creditors might have to take big, upfront losses to make bondholders in overseas subsidiaries whole. That would worsen the panic at home for the reasons described above (and could eventually force Congress to step in with a bailout). All of which is to say that, while resolution authority is clearly a step in the right direction, it raises almost as many questions as it answers.
The good news is that resolution authority isn’t the only way to deal with the problem of too big to fail. Congress could simply break up the banks, for example. Alternatively, if you think of “bigness” as an externality—which is to say, something we get too much of because, like pollution or unhealthy eating, it imposes a social cost that the producer doesn’t entirely pay—then you can discourage it through taxation. (In economist-speak, this would force the banks to internalize the true social cost of their size.) One way to do this would have been to simply impose a tax on the biggest banks, which even conservative economists like Harvard’s Greg Mankiw support. Another way would be to impose stricter limits on leverage for the largest banks—that is, the amount of debt banks can take on relative to equity. Because banks earn more profits when they’re more leveraged (just like you make a larger profit, percentage-wise, when you flip a house on which you put down 5 percent versus 10 percent), this is similar to a tax on bigness.
Alas, none of these things is in the bill that Obama will soon sign. Congress voted down, and the administration opposed, an amendment by Senators Sherrod Brown and Ted Kaufman that would have shrunk some of the country’s biggest banks. Republicans then deployed a variety of underhanded tactics to block a vote on an amendment by Senators Carl Levin and Jeff Merkley that would have shut down the banks’ proprietary trading desks—which is to say, the trading they do for their own bottom line. (The administration and the congressional leadership supported the amendment, which was a relatively strict version of the so-called Volcker Rule.) And, while the government may soon assess a fee on banks to bridge the difference between the bailout money it paid out and the bailout money companies have returned, there won’t be a permanent tax on big banks.
And yet, perhaps unwittingly, the upshot of financial reform will have been to make it costlier to be a big bank relative to being a small or medium-sized bank—which is to say, it has effectively taxed bigness. That’s because the legislation imposes a handful of new mandates and regulations—like oversight by a soon-to-be-established consumer financial protection agency, as well as limits on fees for debit-card transactions—from which small and medium-sized banks are exempt. Other reforms—such as a bill Congress passed last year to limit hidden credit-card fees and make statements more transparent, and new restrictions on trading derivatives—would disproportionately dent profits at megabanks. These banks tend to have far bigger credit card operations, and are the only bona fide derivatives dealers around.
The big banks typically complain that these efforts will drive them out of this or that line of business, or at least curtail their activity significantly. And there may be something to those concerns. But in a world in which we worry about megabanks doing too much rather than too little, that’s not necessarily a bad thing. If only there were a bit more of it.
Noam Scheiber is a senior editor of The New Republic.
*In fairness, the Senate bill does try to avoid this scenario by requiring creditors to pay back anything "above what they would have gotten in liquidation." This should theoretically apply to holders of short-term debt, even if it's years after they were made whole by the initial government intervention. I just think they're unlikely to suffer these losses in practice--it seems difficult (though obviously not impossible) to reverse facts-on-the-ground years later. And, perhaps more importantly, I'm not sure the short-term debt holders themselves can be convinced they'll suffer losses, at least not until it actually happens. Which means they'll continue to underprice their loans, and big financial firms will probably continue to over-rely on short-term debt. On the other hand, we should have evidence of whether or not this is happening fairly soon.
Update: In fairness to the administration and the Dems in Congress, the aim of the bill in many respects is to impose new costs on the biggest financial institutions. My gripe is that there are no bright-line rules stipulating how this should happen--no requirement that, say, firms of X-size must hold Y-amount of additional capital. The approach the Senate bill takes is to have regulators figure out how much additional capital these firms should hold, rather than enforce an amount Congress decrees. Now there are problems with congressional decrees: if you have a bright-line rule, all those smart lawyers the banks employ may find a way around it. But I worry less about that than, say, relying on President Palin's appointees to come up with the prudent level of capital. (Then again, if Sarah Palin is president, we're probably going to have much bigger problems than bank regulation...)
More broadly, because regulators can always fall asleep even if they have specific guidelines from Congress, I would have prefered to see a crude tax on size. Though I aknowledge that, politically, it would have been a pretty tough sell.
Update II: I should point out that David Leonhardt made a number of similar points in his Times column a few weeks ago.