Ordinarily, pointing out that long-standing critic of too big to fail banks is still unhappy about them would not count as news. But the commentary of Dick Fisher, the head of the Dallas Fed, and that of his research director, executive vice president Harvey Rosneblum, is noteworthy because it stands in contrast to the emerging conventional wisdom inside the Beltway. I was told last week that the prevailing and accurate view of last year, that Dodd Frank didn’t go far enough, is being supplanted by the Jamie Dimon view that’s it’s too intrusive. Note that those aren’t actually inconsistent: effective bank regulation IS intrusive. Banker unhappiness would ordinarily be a good sign, but the crisis perps have taken to howling at any intrusion on their imperial right to profit. And the worst is that third parties take their kvetching seriously.
it’s also worth noting that Fisher is decidedly right wing. He thinks the Fed should be more transparent, opposed QE too, and thinks that uncertainty over regulation is deterring business investment (note that this actually shows up as #4 or lower as an issue in most surveys).
What is striking is the way the Dallas Fed annual report puts the TBTF issue as the biggest impediment to a return to prosperity. That’s consistent with an IMF study of 124 financial crises, which found that getting tough with banks and forcing them to recognize their losses (which in the US would have resulted in the radical restructuring of at least Citigroup and Bank of America) produced a deep but short fall in growth and a strong rebound. By contrast, our recovery is barely worthy of the name.
Fisher’s letter in the just-released Dallas Fed annual report describes the concentration in the US banking industry, with the 10 biggest banks holding 61% of industry assets versus 26% two decades ago. And even though Fisher makes a dig over “uncertainty” in fiscal policy, he points out that the real problem is that bank balance sheets are weaker than the banks or the recent stress tests would have you believe:
But to borrow an analogy Rosenblum crafted, if there is sludge on the crankshaft—in the form of losses and bad loans on the balance sheets of the TBTF banks—then the bank-capital linkage that greases the engine of monetary policy does not function properly to drive the real economy. No amount of liquidity provided by the Federal Reserve can change this.
Rosenblum makes a Minskian argument, that the protracted Great Moderation produced too much complacency, although he has a bit more Darwinian tooth and claw in his account than most NC readers will take well. He calls for higher capital levels at the biggest banks and argues they should reduce dividends. He also doubts that Dodd Frank resolutions will work:
Will the new resolution procedures be adequate in a major financial crisis? Big banks often follow parallel business strategies and hold similar assets. In hard times, odds are that several big financial institutions will get into trouble at the same time.14 Liquid assets are a lot less liquid if these institutions try to sell them at the same time. A nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme. In all likelihood, TBTF could again become TMTF—too many to fail, as happened in 2008.
A second important issue is credibility. Going into the financial crisis, markets assumed there was government backing for Fannie Mae and Freddie Mac bonds despite a lack of explicit guarantees. When push came to shove, Washington rode to the rescue. Similarly, no specific mandate existed for the extraordinary governmental assistance provided to Bear Stearns, AIG, Citigroup and Bank of America in the midst of the financial crisis.15 Lehman Brothers didn’t get government help, but many of the big institutions exposed to Lehman did.16
Words on paper only go so far. What matters more is whether bankers and their creditors actually believe Dodd–Frank puts the government out of the financial bailout business. If so, both groups will practice more prudent behavior…
The pretense of toughness on TBTF sounds the right note for the aftermath of the financial crisis. But it doesn’t give the watchdog FSOC and the Treasury secretary the foresight and the backbone to end TBTF by closing and liquidating a large financial institution in a manner consistent with Chapter 7 of the U.S. Bankruptcy Code (see Box 1). The credibility of Dodd–Frank’s disavowal of TBTF will remain in question until a big financial institution actually fails and the wreckage is quickly removed so the economy doesn’t slow to a halt. Nothing would do more to change the risky behav- ior of the industry and its creditors.
The problem is, as we’ve written earlier, is that all the TBTF banks have large trading operations that are tightly coupled via counterparty exposures to other major players. And there is no way to liquidate a trading book tidily.You have to stop the music and value complex positions. No coutnerparty wants to suffer by having positions frozen and assets tied up, so they’ll exit as soon as they sense serious trouble. That’s why Bear went down in less than two weeks. Runs on dealers happen quickly. The best you can do is a Bear-type process, of moving the trading operations into a stronger firm, and that only makes the concentration issue worse. That’s why breaking up TBTF banks isn’t sufficient. You need to reduce the tight coupling, by eliminating or severely restricting the use of the products that are big contributors to the interconnectedness. Credit default swaps top our list.
It’s striking that memories of the crisis have apparently faded enough that the Dallas Fed found it necessary to provide a history. You’d think the specter of high unemployment and millions of underwater homeowners would be a reminder. It serves as a reminder of how insulated people in policy circles are from the realities afflicting ordinary Americans.