Source: At Left, Bombeta de Llum, Wikipedia/User 1997, 2006.

Once they were as gods, but the deities of the American banking system [have] 
    … now  plunged from their pedestals into the maw of taxpayer largesse…

Congressman Dennis Kucinich -  America’s Banking System, 30 Years After Cleveland’s Default, US House of Representatives, 15 Dec 2008.

Once banks were gods, with the power to turn on, and off, the light. 

Dennis Kucinich, Ohio Congressman and former Cleveland Mayor, has described one such incident many times since 1978, when he was Mayor. 

As Kucinich tells it, the city’s commercial banks were once powerful enough to force the city into default after he did not follow through on an ill-conceived transaction to sell Cleveland’s municipally-owned electrical utility to a private, bank-affiliated, venture.

Thirty years later, the firms that tried to rig the electric utility’s sale are either defunct or disgraced, while the city’s electric system “endures”, having just celebrated its 100th anniversary.

Kucinich’s account focused upon the impact of large and powerful banks. I’d like to focus upon those that are large, weak, but too big to fail, even as America’s financial power and (quoting Kucinich)  “debt-based monetary system now lies in ruins.”

This ambitious post will:

1. Examine the regulatory concept of Too Big To Fail;
2. Summarize a defense of banking regulation penned three years ago by a prominent economist before he joined the Fed’s Board of Governors;
3. Highlight the current inconsistent regulatory treatment of failing banks, small and large;
4. Speculate on how to resist regulators’ anti-Darwinian protection of the large and weak.

• Note: The second section (Too Big To Fail, Minimized) is somewhat technical, and you can skip to the third section (Too Big To Fail, Persists) if it’s overwhelming.  However, expect that as the recession deepens, bank failures, large and small, will be the  ‘Page 1′ story of 2009, so you might want to make a copy of (or bookmark) this post for future reference.

TOO BIG TO FAIL, DEFINED

“Too Big To Fail” came into recent use after the 1984 insolvency of Continental Illinois.  Regulators did not have a plan to “resolve” (i.e., fail) the seventh largest US bank.

If Continental had been small, the FDIC would have appointed a receiver, sold the bank’s assets, and protected insured deposits by placing them with another bank.  In that case, uninsured depositors and unsecured creditors would have shared in any losses.

Unprepared, the FDIC protected ALL uninsured depositors and creditors. The FDIC then recapitalized and nationalized the bank and parent by purchasing preferred stock. The FDIC chose new senior management, and fully reprivatized the bank seven years after its original insolvency.

The FDIC took this route because regulators believed that - due to its large size and connections - the failure of the bank or parent would have imposed losses on uninsured depositors and creditors that would have serious and adverse macro-economic effects.

After Continental’s insolvency, Congressional criticism forced the FDIC to narrow the roster of protected stakeholders in other bank “failures” - wiping out holding company creditors even as the FDIC protected bank creditors. 

But as protection against failure became more focused, the definition of “big” was broadened so that when the 250th largest bank - the National Bank of Washington DC - failed, all US depositors were protected.

TOO BIG TO FAIL, MINIMIZED

Dr. Frederic Mishkin published How Big A Problem Is Too Big To Fail?, before serving on the Fed Board of Governors from Sep 2006 to Aug 2008.

In his book review (of Stern & Feldman, see References), Dr. Mishkin suggested that others overstate “the importance of the too-big-to-fail [’TBTF’] problem and do not give enough credit to …  [1991] legislation … for improving bank regulation and supervision.”

The TBTF problem reflects “a lack of credibility of policymakers’ commitment to NOT bail out large banks.”  Economists fear that regulators will inconsistently apply their no-bailout policy:

• …because they want to avoid the systemic risk that [bank failure]… would entail. Uninsured creditors knowing that policymakers have incentives to renege will assume that the bailout will occur and thus will not monitor large banks sufficiently, leading to the too-big-to fail problem.

Dr. Mishkin outlined three motivations for policymakers’ adoption of TBTF:

1. Worry about the economy-wide consequences of large bank failures;
2. Desire to prop up and prevent bank “failures on their watch” that “would make them look bad,” or to curry favor with bankers in order to acquire better jobs when the policymakers return to the private sector; and
3. It makes it easier for the government to use the propped up bank “to lend to whomever the government wants them to.”

Dr. Mishkin summarized Stern’s and Feldman’s views with respect to the relative importance of these three factors with language that reminds us how much things have changed:

• …[The] most important [motivation] is policymakers’ concerns about spillovers. The third motivation is clearly unimportant in the US, because the US government generally stays out of directing bank credit. [emphasis added]

Stern and Feldman believed that the TBTF problem has worsened since the early 1990’s for 5 reasons:

1. Increase in the size and number of large mega-banks;
2. Growing bank importance in payment processing;
3. Increase in use of, and dependence upon, uninsured funding;
4. Increase in bank complexity, making resolution difficult (i.e., “too complex to fail”); and
5. Mergers (of banks with non-bank financial institutions) extended the safety net to conglomerates’ non-bank activities.

Dr. Mishkin wrote while there was “a convincing case” that these forces could potentially strengthen the TBTF commitment to fully protect ALL large bank depositors (and increase risk-taking), this  “does NOT mean that the too-big-to-fail problem is now worse than it was.” 

Rather, Dr. Mishkin suggested that requirements for the “FDIC to close banks with a ‘least-cost’ resolution procedure, …[make] it more likely that uninsured depositors and creditors will suffer losses when a bank fails” and this will limit the TBTF problem.

Stern and Feldman, on the other hand, pointed out that there is a “systemic risk” loophole to the “least cost” requirement, in which regulators can fully protect insured and uninsured depositors.  This permits regulatory protection of uninsured depositors in order to prevent “serious adverse effects on economic conditions or financial stability.”

With the benefit of 20/20 hindsight, it appears that Stern’s and Feldman’s views more accurately described the actual regulatory and interventionist path followed since the beginning of 2008; and that the too-big-to-fail problem is, and was, at least as bad as they suggested.

TOO BIG TO FAIL, PERSISTS

Chris Whalen, of the Institutional Risk Analyst (”IRA”), just pointed out that regulators’ uneven treatment  of large and small banks persists with a couple of examples.

He describes how bank regulators separately closed, and effectively guaranteed ALL of the deposits (insured and uninsured) of two small banks in Texas and Georgia.  In each case, the failed banks received poor ratings on IRA’s proprietary Bank Stress Index, and Whalen praised these interventions:

• Note the courageous stance taken at the local level with smaller institutions, where the state regulators and the FDIC work together to put the good assets into strong hands, thereby improving the overall stability of the system and … its ability to … provide new credit to the private economy.
• It’s not a happy task to resolve a bank and wipe-out bank shareholders, but that purifying process of closure and resolution by the FDIC enables new investors with new capital to make the failed banks assets productive and work for the entire economy.

Source: Chris Whalen, The Institutional Risk Analyst - On the Economy: For Barack Obama, It’s All About Credibility, 17 Dec 2008. 

In Whalen’s view, the Bailout Model used for large banks differs from that employed for small, in that the Bailout Model:

• Does not deal with the problem and ensures a deep recession;
• Suffers from a lack of transparency and disclosure; and
• Will prompt Congressional scrutiny of the Fed, producing a scandal that will shatter “what remains of the central bank’s credibility.” 

Whalen concludes his essay (available here) with the following stark words:

• Strong banks and companies can support a strong economy, but zombie banks with balance sheets polluted by OTC derivatives, subprime debt and other toxic waste are a drag on the taxpayer and the economy.
• The … solution of driving the bad banks out of the system means a quicker recovery from the spreading economic malaise.

TOO BIG TO FAIL, PREVENTED?

The latter half (beginning with page 8 ) of Mishkin’s review contains suggestions to reduce the moral hazards of TBTF, either by limiting failures’ frequency or reducing their macro impact, once they occur.  These include higher capital levels as well as the early shutdown of weakened institutions.

I’d augment this list with the following: limiting compensation of senior bank executives, with backward looking contingencies so that their compensation would be more closely aligned with longer-term full-cycle performance; as well as the perversely opaque encouragement of over-reserving for losses in good times.  This would encourage the build-up of reserves well in excess of what seems to be sufficient during the good times, in advance of the unpredictable bad. 

Finally, if we think in terms of Whalen’s dichotomy (straightforward shutdown versus opaque bailout) believe that regulators will shortly face numerous “opportunities” to consider one or the other.

To promote the selection of “shutdown” over “bailout,” perhaps regulators should be encouraged (and personally rewarded?) to the extent they successfully fight the natural tendency to spread an ever wider safety-net, which occurred after the Continental Illinois insolvency, and persists today. 

But this would require (roughly paraphrasing Mishkin, Stern and Feldman) the appointment of ‘conservative’ bank regulators/supervisors who have both the expertise to deal with financial disruptions as well as the strength to resist the  influence of less-enlightened politicians.

Not a chance.

- - - - - - - - - - - 

I used to work with numbers for a living, but I’m trying to keep my face bright and cheery as I look for my next job or at least an idea.  Till next time.

REFERENCES

George G. Kaufman, Reserve Bank of New Zealand Workshop - Too Big To Fail In US Banking: Quo Vadis? Apr 2004.

Dennis Kucinich, US House of Representatives - America’s Banking System, 30 Years After Cleveland’s Default, 15 Dec 2008. Note: I picked up my title from the Alternet rendition.

Frederic Mishkin, NBER Working Paper 11814 - How Big A Problem Is Too Big To Fail?, Dec 2005.

Gary H. Stern  and Ron J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts, 2004.

Chris Whalen, The Institutional Risk Analyst - On the Economy: For Barack Obama, It’s All About Credibility, 17 Dec 2008.