Too big to fail doesn’t cut it anymore

Warren Coats Contributor
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If AIG, the insurance giant bailed out by the U.S. government, had failed a large number of assets such as mortgage-backed securities would have lost their insurance against losses (called credit default swaps) causing their value in the market to fall.

Such large losses might have caused the bankruptcy of a number of other financial firms holding them and losses to pension funds and other investors who thought they were holding safe (insured) assets. Just the fear that such insurance might not be good caused large drops in the value of insured assets. This is a particularly dramatic example of “systemic risks” from the failure of a very large, interconnected firm that the authorities thought was too systemically important to be allowed to fail. What should regulators do about financial firms that are “too big to fail”?

We might pause to consider how some financial firms got so big in the first place. Markets/investors price risk; they demand a risk premium (higher return) for investments with higher risks of losses. Banks, for example, hold capital (funds put up by owners) to protect depositors from any losses of their funds lent or invested by the bank. The safer the bank’s loans/investments or the larger its capital, the safer are its depositors’ funds. In the 19th century American banks held capital of almost 25 percent of their assets on average and a similar amount of assets were invested in very safe and liquid instruments such as cash in their vaults and government securities. Such conservatism was necessary to assure potential depositors that their funds would be safe. Before the financial crisis of the past two years American banks held (core) capital of around 6% on average. What happened? The Federal Reserve (central bank) was established to provide lender of last resort facilities to banks thus reducing their need for liquid assets, the broadening and deepening of secondary trading of financial assets had the same effect, and the introduction of deposit insurance reduced depositor concerns about their bank’s safety.

Market and government measures that reduced banking risks led banks to take more of them to maintain the balance between risk and return desired by their depositors. To a large extent this was good for the economy by lowering the cost of financial intermediation (spread between deposit and loan rates). But as we have seen recently, banks are now taking too much risk. The expectation that the government (i.e. tax payers) will pick up the losses by bailing out failing banks if too many risky investments go bad, adds a further incentive for banks to increase the riskiness of their investments (heads they win, tails the tax payers lose). The perception that a bank is “too big to fail” (i.e. that its liabilities have an implicit guarantee from the government) is yet another source of “moral hazard” encouraging additional risk taking by banks. As we saw with the now government owned Fannie Mae and Freddie Mac, this implicit government guarantee allowed them to borrow in the market at lower interest rates than their “competitors” and enabled them to grow dangerously large (they now own or guarantee about half of all mortgages in America).

Firm failure and exit is an important part of how markets regulate risk taking and the quality of service. No financial firm should enjoy the government guarantee implied by being “too big to fail.” There is broad agreement with this judgment (see the excellent discussion by Paul Volcker) but less agreement about what to do about it. Overly big banks can be broken up, more heavily regulated than other banks, and/or discouraged (via regulation or taxation) from excessive risk taking or becoming so big.

At the top of my list of measures that should be taken is the elimination of too big to fail firms by reforming financial firm bankruptcy laws to allow orderly liquidation or sale/merger of any financial firm (investment banks, insurance companies, etc) via administrative procedures, as has been the case for commercial banks for some years. If the failed bank resolution tools are not realistic and pragmatic given the nature of banks and other financial institutions they will not be used and these institutions will be bailed out rather than resolved. Regrettably the FDIC (the deposit insurer, which administers failed bank resolutions) has grown lax in recent years in carrying out its prompt correction action and early intervention mandates.

The Obama administration has proposed the establishment of FDIC like measures for systemically important non-bank financial institutions. However, administrative resolution procedures introduce risks of their own that need to be minimized and checked with clear guiding principles for action. Healthy markets and investors hate uncertainty over the rules of the game (the rule of law is preferred over arbitrary action). (The rule of law favors and thus promotes the most productive use of resources, while favoritism promotes the projects of those with the best connections or political skills.) The version of the systemically important non-bank financial institutions bankruptcy law, passed by the House last year, lack such checks. The recent requirement that complex financial firms prepare “living wills” (blue prints for their orderly liquidation if necessary), will also help reestablish market confidence that failing firms will be allowed to fail by reducing the disruption of such liquidations.

Risk taking should bare the full cost of the risk. The Basel Committee on Banking Supervision (the international standard setter for supervising internationally active banks) is already proposing to tighten bank capital standards both by adopting a more strict definition of capital and by raising the capital required for riskier bank assets (so-called Basel 3 risk weighted capital standards). This should go a long way toward reducing the incentive for excessive risk taking by banks. Increasing the amount of capital required for risky assets will also make it easier to allow failing financial firms to go under, by eliminating or reducing losses to depositors and other investors in such firms. But more capital raises the cost of the operation. Safety is not free. Subordinated debt (near capital) provides further protection to other investors at a lower cost than capital, who will thus not be as inclined to run at the first signs of trouble. Another such instrument receiving attention is the use of contingent convertible capital-Coco. These debt instruments are automatically converted into equity (shares) when capital drops below a minimum level. Size and complexity themselves might call for additional capital.

There are many who think that removing the barrier between commercial and investment banking imposed by the Glass-Steagall Act changed to culture of bankers and lead to the excessive risk taking of the last decade. In the same spirit, some economist have long advocated one form or another of narrow banking in which banks that take demand deposits that are used for making payments are limited or even sharply limited in the assets they may hold and hence the risks they may take. This view lies behind President Obama’s recent endorsement of Paul Volcker’s recommendation to limit what banks can do. “The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.” This would isolate banks from the greater risk taking that might be appropriate for some other investors through other vehicles. But to be effective this model would need to be accepted globally and the chances for that seem small.

Regulators failed to prevent excessive risk taking by some financial enterprises and in some respects promoted it. The market should be restored to its role of pricing and thus regulating risk taking by financial intermediaries. A critical element for restoring market discipline is to eliminate the market’s perception that some firms are too big to fail. No firm should be allowed to become too big to fail.

Warren Coats retired from the International Monetary Fund in 2003, where he led technical assistance missions to central banks in over twenty countries. He is Senior Monetary Policy Advisor to the Central Banks of Iraq and Afghanistan. His most recent book, “One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina,” was published in November 2007. He has a Ph.D. in economics from the University of Chicago and lives in Bethesda, Md.