Failure written into 'too big' policy
By Henry C K Liu
The potential failure of banks deemed too big to fail (TBTF) presents
unsolvable challenges for policymakers. The unacceptability of the systemic
impact of such failures on the financial, economic and social order
necessitates government intervention in a market crisis.
Thus far, the official response to the TBTF threat has been focused on
unlimited government protection of big bank creditors from losses they
otherwise would face from big bank failures. Yet creditor expectation of TBTF
protection actually encourages big banks to take more risk, thus pushing them
closer to the cliff of failure, resulting in significant recurring net costs to
the economy and society.
The Barack Obama administration and the US Congress are now
trying to address the fundamental issue of TBTF, generally acknowledged as a
key contributing factor to the near collapse of the global financial system in
2008. Yet, government bailout programs for big financial institutions have
resulted in banks becoming even bigger than before the crisis. Apparently, the
administrationís solution to "too big to fail" is to make banks bigger.
JP Morgan Chase is reportedly holding more than $1 of every $10 on deposit in
the US. The four biggest super banks (JP Morgan Chase, Bank of America, Wells
Fargo and Citibank) now issue one of every two mortgages and about two of every
three credit cards in the US. Since the financial crisis, these four super
banks are each allowed to hold more than 10% of the nation's deposits, having
been exempted from a longstanding rule barring such market dominance. In
several metropolitan regions, these new super banks are now permitted to take
market share beyond what the Department of Justice's anti-trust guidelines
The American banking system is now one of a handful of large global trading
companies pretending to be banks, taking huge profits from high-risk
proprietary trades with government-backed money, instead of one of a network of
small conservative local institutions serving their domicile communities merely
as intermediaries of money through local deposits for nominal fees.
Sheila C Bair, chairman of the Federal Deposit Insurance Corp, described the
TBTF problem as such, "It fed the crisis, and it has gotten worse because of
The US financial system is looking more like a financial trust of a small
number of super banks operating with deliberate moral hazard backed by
ever-ready government bailouts, while consumers are increasingly faced with
fewer choices for financial services from competitive providers.
The Obama administration's efforts to introduce a new regulatory regime to
prevent recurring financial crises triggered by TBTF institutions leans towards
imposing higher capital standards on these super financial institutions and
empowering the Federal Reserve as a super regulator to take over a wider range
of troubled financial firms to wind down their businesses in an orderly way
with minimum loss to depositors.
While adequate capital is necessary for sound banking, the problem with the
banking system today is that it is infested with high-risk propriety trading
that conventional bank capital requirements cannot possibly handle.
Treasury Secretary Timothy Geithner declares the dominant public policy
imperative motivating reform as "to address the moral hazard risk created by
what we did, what we had to do in the crisis to save the economy". Yet there is
little evidence that moral hazard is being reduced or the economy is being
saved. What has been saved is the elite segment of the banking and financial
industry at the expense of the long-term health of the economy, while moral
hazard is now the accepted operating mode for super banks.
Latest FDIC data reveal that the new super banks now can borrow more cheaply
than their smaller peers because creditors assume these large institutions to
be fail-safe. This trend will leave the financial market dominated by a
gigantic trust of interlocking super banks.
Such concentration of market share will hurt consumers in two ways. It will
keep the cost of credit high to borrowers for lack of competition, even when
the costs of funds for banks remain artificially low. It will also push bank
reserves upward to force banks to pass on costs to borrowers.
The White House plan as outlined so far would allow these super banks, whose
failure would put the financial system and the economy at risk, to continue to
exist, but would make it much more costly for them to provide financial
services to the public. The plan would force such institutions to hold more
funds in reserve and make it harder for them to borrow too heavily against
their assets. The plan would require that these super banks come up with their
own procedure to be disentangled in the event of a crisis, a plan that
administration officials say ought to be made public in advance, presumably to
impose market discipline on the largest and most interconnected companies.
Since banks exist to make profits, the bottom line is that the costs of banking
services will increase for both corporate borrowers and the general public.
The administration's plan merely passes the cost of moral hazard to consumers.
What needs to be done is to break up these super banks and the trading firms
that pretend to be banks into regional institutions separated by financial
firebreaks to prevent systemic contagion, and to impose strict limits on
circular hedging. But the administration and its congressional allies continue
to reject such proposals.
Mervyn King, governor of the Bank of England, and Paul A Volcker, former US Fed
chairman, have separately suggested sweeping steps to force the nation's
largest financial institutions to divest their riskier affiliates. King called
for the revival of the Glass-Steagall Act, a New Deal piece of legislation that
separated investment banks from commercial banks.
The solution to the "too big to fail" dilemma intuitively lies in preventing
institutions from getting too big. Yet because of the interconnection of
markets, even failure of small entities in large numbers can trigger systemic
failure. This gives even entities of similar risk profile, but not too big
individually, the ability to cause systemic failure.
In mathematics, the theory of large numbers includes the phenomenon of
exponential growth which occurs when the growth rate of a mathematical function
is exponentially proportional to the function's current value. Such exponential
growth is mathematically unsustainable and will eventually implode.
Multilevel marketing is designed to create a large marketing force by
compensating not only for the sales it generates, but also for the sales of
other marketing forces introduced to the company, creating a limitless
down-line of distributors and a hierarchy of multiple levels of compensation in
the form of a pyramid, such as that employed by Amway Corp. The crisis in
subprime mortgages was caused by massive network marketing, even as each
subprime mortgage individually was only a small contract.
No bank, however big and well capitalized, can withstand the onslaught of a
systemic breakdown of market-wide counterparty exposure built by multilevel
marketing of liabilities, such as subprime mortgages and their securitization.
Thus the problem of systemic market failure is caused not merely by unit
bigness, but also by the absence of firebreaks to prevent unsustainable
exponential growth in risk exposure and the resultant systemic contagion effect
of large number failures from chained counterparty reaction.
It is hard to understand why policymakers are not cognizant of this obvious
fact sufficiently to focus on the need for firebreaks in interconnected
financial markets both to prevent the buildup of risk chain reaction and to
contain systemic failure contagion.
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.