Huntsman’s regulatory reform plan wouldn’t end ‘too-big-to-fail’

Peter Wallison Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute
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The Huntsman plan for regulatory reform is a good effort, but it fails to come close to accomplishing the one major goal that it highlights in its summary description — “ending” too-big-to-fail (TBTF). To do this, the plan proposes a “hard cap” on bank size and would impose fees, higher deposit insurance premiums and higher capital requirements. Of these items, only size matters in the determination of whether a bank is TBTF; the fees, etc. are ways to cause a bank to reduce its size or to compensate for the risks it creates, but do not have any effect on whether it is TBTF.

To understand why this is true, it’s necessary to recognize that there is no particular size that makes a bank TBTF; a bank is TBTF only if, at the time it is near failure, a bank regulator such as the Federal Reserve believes that its failure will cause a systemic financial collapse. There is no way to know this in advance, so in every case we are guessing about the judgment of a regulator’s actions in hypothetical future situations.

This should provide a clue about why the Huntsman plan does not end TBTF. First, no one can know — in the circumstances that will prevail when a bank is teetering on the edge — what the regulator will decide. If the market is very stable at that point, the likelihood of a collapse is much reduced; on the other hand, if many other banks are in trouble at the same time, the regulator may decide that the failure of even a small bank could cause a major run on many other banks. Second, the tendency of regulators is to err on the side of bailouts; the reason is simple: they are heroes if they save jobs and avoid market disruption, and they are goats if a serious disruption occurs on their watch; so all things otherwise equal, declaring a bank to be TBTF is the less risky decision, no matter what its size or the market’s condition.

What this means in practical terms is that size alone is not a determinant. A large bank is more likely to be declared TBTF than a small bank; but a small bank, under particular market conditions, might also be considered TBTF by its regulator. Thus, Huntsman’s proposal for a hard cap on size will not cure the TBTF problem. In addition, for the same reason, most similar statements by politicians and others that they would “break up” the large banks in order to end TBTF are empty talk. Because the deciding factor is the regulator’s judgment at a moment in time, there is no way of knowing what size would be small enough to dissuade the regulator from declaring a particular bank to be TBTF. Accordingly, there is no way to “end” TBTF besides passing a law forbidding regulators from bailing out failing banks. The Dodd-Frank Act certainly doesn’t do that, and it might not be good policy if it did.

On the other hand, the fees, higher deposit insurance rates and higher capital requirements for TBTF banks are a sensible way to approach the TBTF problem. Since TBTF cannot be eliminated, there are policies the government can adopt that will mitigate its effects. Governor Huntsman is correct that TBTF, because it offers creditors government protection in the event of a bank’s failure, provides a funding advantage to banks that are considered TBTF by the markets. This advantage can be reduced with fees, higher deposit insurance and higher capital requirements, but it is important to keep in mind that this is an art, not a science. There is a real danger that piling on these higher costs will actually cause the failure of large banks — the very thing we’d like to avoid — or reduce their ability to lend, a result that would be negative for an economic recovery.

Finally, it is not explicit in the text, but the Huntsman plan seems to be making the serious mistake of assuming that investment banks (like Goldman Sachs) and commercial banks (like Citigroup) are both “banks.” They are not, and it is important to make this distinction. Every entity that lends money is not a bank. Commercial banks are special government-chartered entities that alone have the right to take government-insured deposits and make loans. Investment banks cannot take insured deposits and in general do not make long-term loans. The particular service that banks provide in our economy is converting short-term liabilities (deposits) into long-term assets (loans). Because they can take short-term deposits that can be withdrawn at any time, commercial banks are often the repositories of important business funds, like payrolls. That’s why commercial banks can be TBTF. If a large bank fails, it could have a substantial effect on the businesses and individuals that are its customers.

On the other hand, because they don’t take deposits, nonbank financial firms like insurance companies, securities firms, hedge funds and other financial firms are not likely to be TBTF. This was shown by Lehman Brothers’ bankruptcy in 2008. Lehman was an investment bank, not a commercial bank. It did not take insured deposits and funded itself through borrowing in the financial markets. When Lehman declared bankruptcy, no other company failed because of Lehman’s inability to meet its obligations, even though Lehman was a huge financial institution. To be sure, there was chaos after Lehman’s failure, with many banks and other financial institutions hoarding cash against the possibility that depositors or investors might show up asking for a return of their funds. This occurred because market participants had assumed — after the government rescued Bear Stearns (another investment bank) six months earlier — that the government would also rescue Lehman. When it failed to do so, investors and others panicked, bringing on the hoarding of cash and the frozen markets that characterized the financial crisis.

So the Huntsman plan has some good points, but on the details — especially in its promise to end TBTF — its dog won’t hunt.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.