Are the Largest Banks Too Complex for Their Own Good? Is There A Better Way?

September 30, 2012

Economist Bill Emmons describes the issue of "Too Big To Fail" and its ramifications for the country, and whether this problem can be solved. He explains two broad approaches to reform: 1) radical approaches that include breaking up the big banks and creating "narrow" banks and 2) regulatory approaches that include legislation like the Dodd-Frank Act, international accords such as Basel III that cover capital requirements and the establishment of a "death penalty" regime for failing banks.

Presentation (PDF)


William Emmons: So what about going forward? Is there any way to solve this set of problems? Well, let's go back to that question, why did we rescue the mega-banks? Why did we have the Troubled Asset Relief program, TARP? Well, I would say too big to fail, you've all heard this term. Think about what it means. It means we can't afford to let them fail. And what that means is during a crisis, even though as Jim Bullard said, we need to allow ineffective firms to exit the market. But we found ourselves in the midst of the financial crisis not able to do that. We were trapped. Or as I would say, we were caught flatfooted in 2008 when the financial system almost collapsed and we had no safe, effective way to wind down failing mega-banks. So, in fact, what many people had been saying for many years, that these banks were going to be too big to fail, turned out to be true, that we did not have the means to safely allow them to fail during the crisis.

So can we solve that problem, the too big to fail problem? I would say there are two broad approaches. This is not exhaustive. But I would put in the radical camp, structural reforms. So you've heard people talk about break up the mega-banks. And I'll talk about a couple of different ways to do that. Another would be to create new types of financial institutions. And the one I'll briefly discuss is what's been called a narrow bank. So essentially a payments utility that would separate out what we think is the most critical part of the banking function, maybe, the payment system, separate that from other riskier financial activities.

And then the second broad approach to reform is regulatory reform. So that is keep the basic structure of the banking system in place, but regulate it differently and better. And so I'll speak briefly to the Dodd Frank Act, the most recent large piece of legislation that aims to reduce or eliminate the too big to fail problem. A little bit about Basel III, which is an international agreement dealing with banks. And then throw out something that might also have some effectiveness, what I'm going to call a death penalty regime for failing banks.

So in terms of these radical reform proposals, you can really think following along the discussion earlier, you can aim to reduce complexity or you can aim to reduce size. And, of course, you might achieve both. In terms of reducing complexity, a fair number of people now have been talking about reviving the Glass-Steagall Act, which was a Depression era set of legislation, piece of legislation that separated commercial banking, as I defined it, payments and credit, from other financial activities, in particular, investment banking and insurance underwriting.

Well, remember, it was just over 10 years ago that we've passed legislation, Gram-Leach-Bliley, which opened the door for combining these various activities. So in other words, Glass-Steagall was the law of the land between '33 and '99. In 1999 we reduced, didn't quite eliminate, but certainly reduced the restrictions between combining those financial activities. So that would be one proposal. Let's turn the clock back, in effect, repeal this 1999 act and go back to the previous era.

Another approach would be to reduce the size. So don't necessarily tell banks what they can do, but don't let them grow too big. So you might put a cap, put a limit on the assets they can have, the deposits they can have. In fact, we do have in U.S. law, we do have limits on deposits on a nationwide basis. Or you could even think about limiting the number of subsidiaries they have, if we think of that as some measure of complexity. I just throw out one, and the general point is we've been over the last 20 or 30 years basically moving in a deregulatory direction. So the Riegle-Neal Act of 1994 opened up interstate branching, and that was one, not the only, but certainly one of the legislative initiatives that really allowed much larger banking organizations to form. And if you remember that time series plot, the very large concentration, a lot of that interstate branching, of course, was done to create very large organizations that operate coast to coast.

The other radical reform proposal is what I called narrow banks. So separate out the payments function of banks from all other financial activities. So it would be a bank that could take deposits and you could make your payments, but instead of making loans that narrow bank would be restricted to holding only say short-term Treasuries so that there would not be any risk of the bank defaulting. This actually has a long, long history. Even back in the 1930s there were economists who were in favor of this sort of an idea.

The questions that have always been raised is would narrow banks be viable? That is, could they make enough money to survive on their own? And I think most people would argue probably not; certainly not in today's environment. This is essentially what a money market mutual fund is, and on a standalone basis, I don't think any of the money market mutual funds today are viable. They're all being subsidized by their parents in one way or another.

Another question is could we keep other firms out of the payment system? And that is a battle that the Fed has been fighting for a long, long time. There's a strong incentive to provide payment services as an adjunct to lots of other things. For example, Amazon would like to get into the payment system. Walmart would like to get into the payment system. And it's been difficult to try to maintain this wall between the financial, especially the payments part of the financial system and the non-financial system.

So those proposals are out there. I personally don't think that they are likely to be successful for some of the reasons we've talked about. But if you have ideas about this, we can discuss that too.

Moving on to the regulatory side. Well, Dodd Frank was passed in 2010 and there are a number of provisions that aim to reduce or ideally eliminate the too big to fail problem. So the act is organized in titles. And I'm just highlighting a few that are designed to make the individual institutions easier for them to fail and the overall financial system more stable. So in this first title we created two new bodies, the Financial Stability Oversight Counsel and the Office of Financial Research. They're just in the process of getting up and running now and so it's really way too early to know how effective they might be. This title also increased the amount of cash capital the banks must hold, which is, of course, an old, old idea that regulators have put a lot of emphasis on over the years. More capital to protect the depositors and the Deposit Insurance Fund and make those institutions less likely to fail.

We've created something called a living will requirement. So certain groups of financial institutions must provide detailed instructions on how they would be dismantled. How the regulators would take apart these firms in a failure situation. We now have requirements, the regulators to run stress tests, so simulate stressful environments and see where the weaknesses are in financial institutions.

We have risk-based assessments on deposit insurance that would be imposed on SIFIs. And if there is a failure among these large groups, the costs will be allocated and collected on by the other institutions.

There is something created called the Orderly Liquidation Authority, which is an alternative to bankruptcy. It's supposed to be a roadmap for winding down these large systemically important financial institutions. We have the Volker Rule, as I mentioned briefly before, which was to require depository institutions to stop trading for their own account, or at least that's the general intent, to reduce their investments in risky firms, private equity funds. Also some tightening up of internal governance requirements.

We also have in Title 9 annual disclosures of incentive compensation arrangements for certain institutions. Also some requirements that board of directors must approve compensation arrangements. So, again, sort of pushing banks to be more effective in these internal forms of self-discipline.

Basal III, as I said, was an international accord. It includes things like changing what we call capital, what qualifies as owned funds for the institutions. So a lot of this, of course, is more technical information than you really may need, but it has made it more difficult for financial institutions to claim that they are well protected against failure. So they have to show essentially more skin in the game, more capital to support their operations.

We've raised a couple of different kinds of capital requirements, simple calculations, but also more complex calculations of how much banks need to hold. We've also put into place the idea that when times are good, banks should be building up more capital so that they can withstand big downturns. We've also recognized that something like what happened in 2008 with lock-up in liquidity markets needs to be addressed before the fact. And there have been all sorts of procedures to try to help banks measure their risks better.

Will this be effective? Of course, we don't know yet.

The last thing I'll point out, or suggest is really not that radical when you think about it. I'm calling it a strict death penalty regime. What if we had a law that said that any bank that requires government assistance will be nationalized and we will plan then to sell it back to new shareholders at some point in the future? The idea is if that is more or less guaranteed, now of course, that's the crux of the matter. Could we in fact carry through on this pledge? It should reduce the incentives to take risks because of such a severe penalty. Of course, that's the theory of the death penalty in general, is that it's such a severe penalty that it should act as a deterrent.

As you know, we created the Troubled Asset Relief Program in 2008, TARP, which allowed government to take equity positions in the mega-banks but I would point out that they were passive positions. They were preferred equity, not common equity. And they were limited. They were not controlling stakes. So it was very much a weak equity position in those institutions. It didn't wipe out shareholders or management.

We did, and this is what I say, it's not actually that radical when you think about it, we actually did impose the death penalty on Fannie Mae and Freddie Mac. Their shareholders and management were wiped out. General Motors was forced into bankruptcy, as was Chrysler. And AIG, wiped out the shareholders and the management.

If this were to be our plan we would need sort of standing by, to continue the metaphor, an undertaker, an institution that would be ready to exact this discipline on the firms. During the crisis we had to pass legislation, the TARP legislation to even get that relatively minor equity participation that we had.

How would we do this? Well, many countries have what's been termed a sovereign wealth fund. It's a permanent institution that can take equity positions in firms. So maybe that belongs in the radical category. I think it belongs in the regulatory reform category.

So that's what I wanted to say. And before we get the panel up here, I wanted to revisit this question. Given what you've heard, which of the following statements best expresses your views on big banks? These are the same as you saw before. Okay. Ready?


Okay, so we lost some support from number 4, I think. And pretty strong support for number 3. Don't think we need big banks and they are a clear and present danger to the economy. Okay, very interesting.

This popular lecture series addresses key issues and provides the opportunity to ask questions of Fed experts. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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