Too Big to Fail, or Too Connected?

About a month ago Governor Jon Huntsman went to the pages of the Wall Street Journal to argue that too big to fail was simply too big.  It opened a line of attack on Governor Mitt Romney, who has said he opposed the bailouts but couldn’t answer a question on TARP clearly.  With Gingrich rising and Huntsman grasping for anything that could lift him in New Hampshire, banking — and Gingrich’s ties to Freddie Mac — might be the answer. 

So this morning Huntsman went back to his Too-Big-Too-Fail-Is-Too-Big (or, #2Big2FailIs2Big, for those of you looking for a Twitter handle) theme with a more detailed plan that has some people positively gushing. Business Insider offers a synopsis:

  • Set a hard cap on bank size based on assets as a percentage of GDP. (This cap would be on total bank size, not using any of the illusory “risk-weights” currently central to thinking about bank accounting… )

  • We should have a similar cap on leverage—total borrowing—by any individual bank, relative to GDP.
  • Impose a fee on banks whose size exceeds a certain percentage of GDP to cover the cost they would impose on taxpayers in a bailout, thus eliminating the implicit subsidy of their too-big-to- fail status. 
  • In addition, focus on establishing an FDIC insurance premium that better reflects the riskiness of banks’ portfolios. 
  • Strengthen capital requirements, moving far beyond what is envisioned in the current Basel Accord. 

Well, let’s first recall two facts.  First, our banks are not particularly large.  At latest data, JP Morgan Chase is only the 9th largest in the world; Bank of America, Wells Fargo and Citi are the only others in the top 50. It would be difficult to calibrate an asset limit that hit more than these four, and hard to calibrate one that didn’t hit all four (or none.)  Not long ago there was a fifth, Wachovia, which is now part of Wells. 

Second, we still manage to have more than 6000 commercial banks in the United States, and those top 4 banks hold less than 50% of all deposits. To put that in context, 7 banks in Canada control more than 90% of deposits.  We have consolidated banking over the last 30 years, and that has been a benefit to many through greater financial services and competition.  Despite that, we are still the least concentrated banking system in the industrialized world.

My main problem with the Huntsman plan is not his analysis.  We do have banks that create systemic problems — those four, plus some of the investment banks that we decided to place in our care. The problems have been known for years.  We created the FDIC Improvement Act to put an end to this.  As Vern McKinley and Gary Gegenheimer pointed out, we failed to use the law.  Why do we think we would ever get to enforce the Huntsman plan, even if it passed? How much of it would be deferred in the law to rulemaking by a Treasury Department, and FDIC and a Federal Reserve that appear captured by the Big 4? 2B2FI2B is an issue because of rent-seeking firms with armies of lobbyists who pervert the rule-making process.  Huntsman is silent on resolving this, even though he recognizes the failure of Dodd-Frank (and seeks its repeal.) 

It’s not so much too big to fail, it’s too connected to fail.  How does Gov. Huntsman (or any of the other candidates) propose to end the connection?

 The points above do not cover the Huntsman plan for non-depository financial institutions like Goldman Sachs.  For this, the Huntsman plan also mentions a tax reform plan that would remove the deductibility of interest for businesses in return for rate reduction, which would decrease the incentive to leverage up investment banks. 

On this, I think he would find many good conservatives in support.  Indeed, for a guy who was supposed to bring foreign policy chops to the presidential race, it’s odd that I find the Huntsman tax plan his most appealing feature.  And the interest rate rule change would burnish his credentials as a non-Wall Street candidate.  (I’m probably the only person waiting for a GOP debate to include a question on carried interest.  There’s a reason economists aren’t invited to these things!)

Let me close with one last point.  The Federal Reserve Banks — those twelve districts with seats outside DC — have been long aware of this issue.  In particular the Minneapolis Federal Reserve made 2B2FI2B a cause years ago, and a recent speech by Dallas Fed president Richard Fisher calls for financial lap-band surgery.  (h/t Simon Johnson, whose article is also relevant.)  If Governor Huntsman wants to find economists and policymakers with background and inclination to reduce systemic risk from large banks, it’s available. 

  1. Duane Oyen

    Romney’s answer struck me as OK politics- staying on message when the question is 2hot2be_specific. 

    And I clearly recall Dr. Banaian reluctantly acknowledging on the Northern Alliance Saturday radio program in 2008 that TARP 1, as it was originally advertised, may be the least bad approach at the time.

    But for the record, even Arnold Kling, who is as libertarian as any economist out there, along with solid insider knowledge (Freddie Mac refugee, before the fall), strongly believes that the only solution is to break up the banks, while Minneapolis Fed’s Gary Stern believes that discretion is necessary.  That clears everything up!   

    My own view, with zero credentials in support, is that this can be easily effected by re-introducing the concept of risk to the bank managers. For example, defer a significant portion of compensation until five years of financial reports have confirmed value rather than cooked books, and force every institution that wants to ever be eligible for a bailout of any kind to sign up executive employment agreements to require that the top layers of management be fired immediately and subject to clawbacks as a condition of accepting the federal support.  

  2. Midget Faded Rattlesnake
    King Banaian:

    It’s not so much too big to fail, it’s too connected to fail.  How does Gov. Huntsman (or any of the other candidates) propose to end the connection?

    I don’t know. But I do wonder whether his proposed solution of just calling some banks “too big” wouldn’t ultimately make the problem worse.

    I’m reminded of how antitrust cases are more easily won against smaller firms (“local monopolies”) because smaller firms lack the clout and flotillas of lawyers necessary to contest the charges.

    The last thing we need is a rule intended to break up banks that are “too big” that’s harder to enforce against larger banks than smaller ones.

  3. Ed G.

    Wouldn’t a policy of no bailouts be more effective, less costly, more respectful of liberty, and clearer than a policy of Too-Big-To-Fail-Is-Too Big? What makes Huntsman think that “we” have the ability to adequately direct, let alone optimize, the financial transactions of the economy?

  4. Midget Faded Rattlesnake
    Ed G.: Wouldn’t a policy of no bailouts be more effective, less costly, more respectful of liberty, and clearer than a policy of Too-Big-To-Fail-Is-Too Big? What makes Huntsman think that “we” have the ability to adequately direct, let alone optimize, the financial transactions of the economy? 

    I’m wondering the same thing…

    ….perhaps transitioning back to a no-bailouts policy is about as easy as putting toothpaste back in the tube. But if we don’t do it sometime, where does that leave us?

  5. King Banaian
    C

    Yes, I was pro-TARP as it was passed, just not the one they actually did.

    Duane Oyen: 

    My own view, with zero credentials in support, is that this can be easily effected by re-introducing the concept of risk to the bank managers. For example, defer a significant portion of compensation until five years of financial reports have confirmed value rather than cooked books, and force every institution that wants to ever be eligible for a bailout of any kind to sign up executive employment agreements to require that the top layers of management be fired immediately and subject to clawbacks as a condition of accepting the federal support.

    European banks are not raising capital right now because they don’t want to dilute their shares.  What if we had conditional stock options — a sort of loan-for-shares — that would trigger on capital ratios falling below some level?  Automatic shareholder haircuts, to be paid by bondholders, who are now on the hook.  Gets better supervision by those with skin in the game.  I know I heard this idea from someone else, but right now can’t remember where I heard it.

  6. Duane Oyen
    King Banaian: Yes, I was pro-TARP as it was passed, just not the one they actually did.

    Duane Oyen: 

    ………. this can be easily effected by re-introducing the concept of risk to the bank managers. For example, defer a significant portion of compensation until five years of financial reports have confirmed value rather than cooked books, and force every institution that wants to ever be eligible for a bailout of any kind to sign up executive employment agreements to require that the top layers of management be fired immediately and subject to clawbacks as a condition of accepting the federal support.

    European banks….. don’t want to dilute their shares.  What if we had conditional stock options ………. trigger on capital ratios falling below some level?  Automatic shareholder haircuts, to be paid by bondholders, who are now on the hook.  Gets better supervision by those with skin in the game.  I know I heard this idea from someone else, but right now can’t remember where I heard it. · Nov 28 at 8:21pm

    Professor Banaian, how does that capitalization approach discipline the executives?  Russ Roberts talks about the relatively meaningless difference between extremely rich and just very rich bonuses.

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