End ‘Too Big to Fail’ in 2 Easy Steps

This is a post which originally appeared at New Deal 2.0 by Randall Wray.

L. Randall Wray, Ph.D. is Professor of Economics at the University of Missouri-Kansas City, Research Director with the Center for Full Employment and Price Stability and Senior Research Scholar at The Levy Economics Institute.

Chairman Bernanke has rightly argued that the nation’s behemoth banks represent the “most insidious barriers to competition in financial services”. He went on to admonish that “it is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.”


Rahm Emmanuel has supposedly told President Obama that this crisis represents a valuable opportunity for real change that cannot be wasted. Now that the Chairman is finally on board, the President must grab the reigns with two hands. Bernanke is right that we must use this crisis to eliminate the outsized risks that a few financial firms pose to the whole economy.

Unfortunately, Bernanke’s three-part strategy for reform falls short. First, he calls for “tougher rules and oversight” — something that sounds good, but will become so watered-down after Wall Street’s lobbyists are done that it will not do any good. Further, any institution that is “too big to fail” is also too big to understand, let alone to supervise. Rules and oversight cannot substitute for downsizing.

Second, he wants to improve the resilience of the system. Again a good, albeit vague, idea. Given complex financial instruments, highly leveraged and layered balance sheets, and mostly unknown linkages among institutions, this will be a very difficult undertaking fraught with opportunities for Wall Street to impose its self-interest on Washington. Downsizing is a pre-condition to improving resilience.

Finally Bernanke proposes a process to seize and resolve failing mega-institutions by selling, merging, or breaking them up. Great idea, but it is not new — indeed, it is the law of the land, a law that is currently flagrantly violated by our regulators at the Fed and Treasury. Which raises the question: why wait? The behemoths ARE failing; every one of them would have been shut down by markets if not for the trillions that Bernanke and gang pumped into them. Remove the support and they would close each other in a massive orgy of self-cannibalization. Unfortunately, most resolutions to date have taken the form of subsidizing greater concentration while increasing risks posed by the remaining giant institutions. Again, without downsizing this does no good at all.

Indeed, when the last remaining investment banks — Goldman and Morgan Stanley — were shut off from market funding, Bernanke handed them bank charters so that they would have unlimited access to low-cost government insured deposits. This not only helped them to remain “too big to fail”, but it also put the FDIC on the hook should they fail. As we know from the experience with the saving and loan crisis, the exposure of the insurer’s reserves to losses is always a factor determining how much forbearance is provided to an insolvent institution. Part of the reason the other investment banks were allowed to fail is because they were NOT insured.

My colleague Bill Black calls these megabanks “systemically dangerous institutions” — far more apt than the administration’s preferred nomenclature, “systemically important”.  Perhaps Bernanke’s statement that it is “unconscionable” that we would let a handful of giant banks hold the world’s economy hostage reflects a not-so-subtle shift of thinking that also seems to be reflected in some of the President’s statements. Dare we have any audacity of hope left?

In case you do not know who Bernanke is alluding to when he mentions “insidious” financial institutions, the following graph reports the share of bank assets held by the top four-over two-fifths today, up from less than 15% through the mid 1990s:


And here is the share of assets and deposits held by the top 18-about 60% of assets and over half of deposits:


Finally, here is an alternative way of determining absolute and relative size, by market capitalization (share of the capitalization of the top 29 banks before the crisis, and of the top 23 after the crisis):

Absolute and Relative Size of Largest Institutions


Source: New York Times for October 2007 and March 2009; Yahoo Finance for January 26, 2010

As of the end of January, all but Wells Fargo (which obtained Wachovia when it failed) had lost market value since the peak of October 2007. Still, all but Citi (as well as AIG and Fannie and Freddie-all three of which are “special cases”) had actually improved market share. Leaving to the side AIG, the top five (Citi, BofA, Chase, Wells Fargo and Goldman) increased their market share from 46% to 68%. For Chase, Wells Fargo, and Goldman, the improvement was remarkable. Thus, the biggest financial institutions are surely following Emanuel’s dictum that one should take advantage of a crisis — even if the Obama administration has not yet done so!

Clearly there was a dramatic concentration of banking over the 1990s and early 2000s. Not coincidentally, this coincided with the explosion of innovations that changed the focus of the biggest banks away from making and holding loans in the case of commercial banks, or from underwriting and placing corporate equities and bonds in the case of investment banks, to trading. In 1999 Washington eliminated any separation between investment and commercial banking, allowing all of the big institutions to focus more of their business on marketing risk-earning fee income by selling products (largely derivatives, including asset-backed securities) to money managers, as well as trading for their own account.

Around the same time, the remaining big investment banking partnerships went public. This essentially replicated the conditions of the late 1920s when Goldman and the other Wall Street firms formed subsidiary investment trust companies that issued stock — then manipulated balance sheets and markets to drive up their values to benefit the partners at Goldman and other investment houses. As J.K. Galbraith wrote in The Great Crash 1929, “It is difficult not to marvel at the imagination which was implicit in this gargantuan insanity. If there must be madness something may be said for having it on a heroic scale.” (p. 64) It is of course heroic madness déjà vu all over again as top management manipulated stock prices to goose their bonuses.

As Roger Lowenstein correctly explains, since the 1990s, activity of the biggest banks was mostly divorced from the “real economy” and did not really contribute to growth of productive capacity or income.  In other words, ability to service debt did not increase, but Wall Street leveraged an essentially given income flow with ever rising debt and risk. In spite of the trillions of dollars of mortgages that were securitized, “homeownership increased only a trivial amount”. Indeed, we financed production of more new homes back in the early 1970s without any involvement of Wall Street. All we got was much more debt — as Wall Street increased its share of national income and corporate profits.

Lowenstein also rightly argues that the Wall Street institutions no longer serve any public purpose: “At Goldman, trading and investing for the firm’s account produced 76 percent of revenue last year. Investment banking, which raises capital for productive enterprise, accounted for a mere 11 percent.” And what kinds of trades and investments does Goldman pursue? It helps Greece and other clients hide debt, and then it bets they will default. These firms act against the public purpose, as Blankfein uncannily admitted to the Financial Crisis Inquiry Commission when he said that “we represent the other side of what people want to do.” You want to buy a house, build a factory, or provide government services to your citizens? Goldman wants to bet that you will fail.

So how do we get to the elimination of Bernanke’s “insidious” too-big-to-fail institutions? We will not get there through increased regulation or supervision; we will not get there by improving system “resilience”; and we will not get there by propping them up with trillions of bail-out funds whilst waiting for them to fail so that we can resolve them.

So let’s try a much simpler, two-pronged approach.

1. After January 1, 2011 the FDIC will no longer provide deposit insurance to any financial institution that holds more than a one percent share of insured deposits. For the purposes of calculating market share, a bank holding company must include deposits of all subsidiaries — with the one percent share restriction applying to the aggregate total.

2. After January 1, 2011, institutions that issue FDIC-insured deposits are restricted to holding cash, reserves at the Fed, whole loans and corporate and government bonds. They may not hold any securitized products or derivatives; they may not move anything off-balance sheet; and they may not hold interest in any subsidiaries that are not subject to the same rules.

These two measures will eliminate most of the advantages to bigness. By restricting access to insured deposits, large institutions would face much higher costs of raising funds. The megabanks examined above would have to choose whether they wanted to become smaller, “narrow banks” or to remain “universal banks” albeit without access to insured deposits. It is expected that under such conditions, the market would downsize most of these institutions and that the trend toward concentration of deposits in the hands of a few megabanks would be reversed.

To help the market to discipline the biggest financial institutions, returning Wall Street to a more appropriate role in the economy, the President would direct all relevant officials to issue statements prohibiting their departments or agencies from intervening to prevent failure of any financial institution or financial arm of any corporation or partnership. Implicit and explicit guarantees of all liabilities would be removed, with the following exceptions:

a) liabilities of the US Treasury and other US federal government agencies, including but not restricted to Social Security (OASDHI), federal pensions, Fannie, Freddie, and Sally
b) FDIC insured deposits as described above
c) liabilities of the Federal Reserve
d) other liabilities specifically approved by Congress

These actions would reduce lingering confusion regarding the possibility that the government would bail out a troubled behemoth — which gives the biggest institutions the benefit of the belief that government might rescue them. The President has called himself a “vigorous defender of free markets” and said that under no circumstance would the government defend any large financial institution against an attack by the market. These recommendations let him put his money where his mouth is.

To take this a bit further, I would put the GSEs (back) into government — with direct government loans made to low income homebuyers, to college students and to small farms and business. There would be no reason to guarantee these mortgages or loans since Uncle Sam would take the risk and cut out the middleman. Of course, in these cases the government has already found that the market does not work (otherwise there would be no reason for government support of lending to low income homebuyers, students, and small farms and business). So there would be no reason to try to use the market to provide such loans, nor to enforce market discipline if the loans go bad.

But in those areas in which the government believes markets do work, there should never be any intervention to subvert market forces that want to punish miscreants. Treasury Secretaries Rubin, Paulson, and Geithner’s repeated claim that we cannot allow market forces to operate on the downside is logically nonsensical. Markets cannot work if downside risks are removed. In any area in which the downside is going to be socialized, the upside MUST also be socialized — that is, removed from the market. If the market is to work on the upside, it must be allowed to operate also on the downside.

What about systemic risk? Yes, if government had allowed markets to operate as Bear and Lehman went down, all of the big financial institutions would also have been brought down. As Bernanke now apparently realizes, that would have been a good thing. The market would have accomplished what Bernanke now professes to desire: resolving the problem of “too big to fail”. We would have been left only with smallish institutions — those not too big to fail. And as Lowenstein forcefully argues, those big financial institutions do very little that is desirable from a public purpose perspective. Whatever good they do accomplish can just as easily be done by small institutions or directly by government where the market fails.

After all, this ain’t rocket science. It is just finance: determine who is credit-worthy, provide a loan financed by issuing insured deposits, and then hold the loan to maturity. If the underwriting is poor, the institution will fail and the government will protect only the insured depositors. No individual institution will have an incentive to grow quickly (rapid growth is almost always associated with reducing underwriting standards, and fraud) since once it reaches a one percent share of deposits its access to more insured and cheap deposits is cut-off. Small institutions would not have to compete against the large “systemically dangerous” institutions that now enjoy a huge advantage because even their uninsured liabilities are thought to have the Treasury standing behind them. With a level playing field, even “average skill and average good fortune will be enough”, as J.M. Keynes put it.

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