Solving Too Big Too Fail
When the epitaph is written for the era of crisis and bailouts, "Too Big to Fail" will undoubtedly be on the gravestone. This week the House Financial Services Committee, chaired by Barney Frank, is revising marked-up legislation intended to solve the "too big to fail" (TBTF) problem in order to take into account concerns about funding and moral hazard. Following the twists and turns of the reform can be confusing, even mind-numbing, so, as a guide, let's look at several of the problems that happened over the past few years in the financial sector, and see how legislative efforts have attempted to address them. (Spoiler alert: not very well.)
Problem 1: Several financial companies that were not traditional banks were deemed too systematically important to be allowed to fail through the normal bankruptcy route.
"Too big to fail" is a bit of a misnomer. The issue is better explained as "too interconnected to fail." A financial institution is a business; a business is just an experiment in the game of capitalism; and it is in the nature of experiments to fail. Our regulator's goal isn't to make a system in which there are never failures but a system in which failures are cleaned up in an orderly and nondisruptive fashion. Like an elaborate game of Jenga, even removing the smallest piece can collapse the entire structure, and regulators need to be able to remove any piece without having the entire real economy collapse.
There are two ways the current legislation approaches this task: first, regulators will keep firms from becoming too risky as a proactive measure; second, the legislation will make it easier to resolve a financial institution when things do fail. The bill will create a Financial Oversight Council, consisting of the major government regulators, that will determine in advance which nonbank institutions will be designated Financial Holding Company Tier 1 and fall under the umbrella of heightened scrutiny. These are the potential TBTF firms.
Problem 2: The largest financial institutions took on too much debt and leverage and had too little liquidity to survive a financial shock–they were too risky. When regulators pointed this out to financial institutions, such as Lehman Brothers, they had little regulatory power to force any preventive actions.
So once a financial firm is considered to be a target of extra scrutiny by the Financial Oversight Council, what happens? The reforms will have the Federal Reserve take these institutions and put them under additional rules that the Fed will figure out later and handle on a case-by-case basis. The Fed gets a lot of power and a lot of leeway–"the Board may require the identified financial holding company to sell or otherwise transfer assets or off-balance sheet items to unaffiliated firms, to terminate one or more activities, or to impose conditions on the manner in which the identified financial holding company conducts one or more activities." But how well will the Fed use this power? And what will guide it?