Suggestions from two Fed officials on reducing the dangers of Too-Big-To-Fail banks

The president and EVP of the Dallas Federal Reserve Bank have three suggestions in the Wall Street Journal on How to Shrink the ‘Too-Big-To-Fail’ banks.

The problem

Only 0.2% of the US banks control 70% of the assets in the industry. Those few banks are two-big-to-fail, too-big-to-jail, and even too-big-to-prosecute. They get special treatment from the federal government, specifically an explicit guarantee they won’t be closed, which gives them lower borrowing costs which means they have a government-sponsored competitive advantage.

Why that matters

Here are a few consequences mentioned in the article:

This is patently unfair.

{the} playing field {is} tilted to the advantage of Wall Street against Main Street

…these banks … can take excessive risks

…the financial system {is} in constant jeopardy.

…citizens’ faith in the rule of law and representative democracy {is underminded}

…market discipline is still lacking for the largest dozen or so institutions

I would point out that two-big-to-fail is also crony capitalism. That means the government has picked certain companies to be favored by the government and protected. Everyone else is on their own. That inevitably produces distortions and disincentives. See the preceding list of consequences mentioned by the authors.

The authors assert the Frank-Dodd bill won’t end the ‘too-big-to-fail’ phenomenon. They insist 849 pages of legislation with 9,000 pages & counting of regulations won’t change things. Who could possibly understand all that and how could those regs be enforced fairly and consistently?

In fact, I think Frank-Dodd will strengthen the megabanks and put every other financial institution at a competitive disadvantage.

Here’s a very simple illustration from my little brain.

Let’s say you come up with some cool idea for a credit card feature that will make cards less costly and more appealing to consumers.

Can you take that idea to market? Only after you review the 849 pages of legislation and over 9,000 pages of regulations to make sure you don’t somehow break the law.

Same story for every new idea, product, feature, and service offered by banks.

Who has the capacity to understand all those regs? Oh, and who is possibly going to be able to follow all the case-law which will inevitably follow? The megabanks will continue to have a competitive advantage because of their size and that advantage will grow.

Three suggestions

Their three simple suggestions, which I quickly summarize:

First, allow federal deposit insurance only for the portions of the megabanks that are commercial banks. End insurance coverage for any investment in their affiliates, non-bank subsidiaries, and the holding company. This introduces market discipline.

Second, require every depositor or investor in those now-uninsured entities to sign an acknowledgment they know their investments are not guaranteed by the government.

Third, require the holding companies to restructure all of their subsidiaries into separate corporations that are individually small enough to fail. That means splitting out the large entities into multiple small entities that stand on their own organizationally and legally.

If any one of those entities get into trouble, it can be liquidated in the same way as happens every week amongst the other 99.8% of banks. Those individual failed subsidiaries can then …

{fail} with finality when necessary—closed on a Friday and reopened on Monday under new ownership and management in the customary process.

The authors call this ‘too-small-to-save’.  I like that phrase.

I doubt those changes will ever go into effect. However, those are great ideas and show there are possibilities that would actually reduce the danger to the rest of us of ‘too-big-to-fail’.

Check out the full article.

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