With the economy doing better it may seem like an odd time to worry about the issue of “too big to fail” (TBTF) and the potential fall-out that would accompany the collapse of a major financial institution. In fact, the worries are still there and we are likely to see a renewed TBTF debate in Washington this year.
Why is this important? The failure of huge financial institutions several years ago required a $1.7 trillion government bailout and resulted in as much as $15 trillion in damages through the economy, according to Cornell University Law School. Seen another way, the value of your home and your retirement accounts, the certainty of your job, could again plummet with another wave of big bank failures.
The TBTF debate centers around 35 or so “systemically important” organizations which are so huge the failure of anyone of them could impact the entire U.S. economy, according to the Congressional Research Service. Under Dodd-Frank these financial behemoths include bank holding companies with assets of $50 billion or more, insurance giants AIG and Prudential as well as a nonbank, GE Capital.
Some believe that MetLife, an insurance company, should be on list as well as mortgage giants Fannie Mae and Freddie Mac, two firms now operated by the government. Alternatively, others argue that nonbanks should not be on the list at all: Last year the House passed legislation which would prohibit nonbank additions to the current list.
It might seem as though too-big-too-fail should not be an issue because it was addressed in the 2010 Dodd-Frank legislation, but that’s actually part of the problem. Wall Street reform says under Title II that two things can happen if a large financial organization gets into trouble: It can go bankrupt or it can be taken over by the FDIC.
Both options are contentious.
It might seem as if bankruptcy is a reasonable option but in practice that may not the case. If Fred’s Apple Stand fails then Fred goes out of business and life moves on. If First Goliath Bank closes the results are not so simple. An end to FGB could mean massive disruptions throughout the economy, a financial ripple-effect that damages millions of people.
A take-over by the FDIC is also unattractive because to many observers it seems like another government bailout. Nobody helped Fred when the apple stand failed so why should First Goliath get special treatment just because it’s large?
The problem is made more complex because of two major issues:
First, with implicit government backing Goliath can borrow at lower rates than competitors, thus merely being labeled as “systemically important” creates massive financial advantages.
Second, a “bank holding company” is not a bank, it’s a vast financial conglomerate with a diversity of interests. Should taxpayers bail-out a bank holding company because nonbank investments went sour?
Think of derivatives as an example: According to the Treasury, in the second quarter of 2014 U.S. banks — meaning almost exclusively big banks — had derivative bets with a notional value of $236.8 trillion. In theory these swaps should balance out but what if the theory is wrong? What if one unfortunate bank trader bets the house — and misses the mark? Just think of the 2012 “London Whale” bets, a mini-quake that resulted in losses of $6.2 billion for JP Morgan Chase as well as $920 million in fines.
Too Big To Fail
“In no way, shape or form does the Dodd-Frank Act end ‘too big to fail,'” says House Financial Services Committee Chairman Jeb Hensarling (R-TX). With both the House and the Senate controlled by Republicans it’s a view to take seriously.
How Dodd-Frank will be changed, if at all, is unclear. Will the whole thing be tossed out or just a few parts? For instance, the 2010 legislation contains a provision which bans federal bailout assistance for “any swap, security-based swap, or other activity of the swaps entity.” As part of the 2014 budget bill the swaps limitations were essentially repealed, meaning potentially that taxpayers could be responsible for big losing bets.
In reality all the debate, lobbying and arguments are likely irrelevant. The question of what to finally do about financial institutions which are “too big to fail” is an academic matter unless and until one actually goes belly up. Any legislation on the books can simply be re-written to reflect whatever decisions will be made at that time — decisions which may be very different than anything now under discussion.