GECON200-Topic #5: Too-Big-To-Fail

The financial system in the United States has been under stress since about the beginning of 2007 when the housing market began to collapse. Since 2007, hundreds of banks have been shut by the FDIC, but these banks aren’t the biggest problem in the U.S. Since the beginning of the FDIC, banks pay insurance fees to the FDIC in order to help depositors at those institutions from losing all of their money when a bank fails. However, this creates a problem for regulators since banks that take bigger risks are protected at a limited expense to any individual shareholder or employee. The problem of moral hazard exists in banking explicitly because of the FDIC, but also exists implicitly if the U.S. government stands ready to bail out any financial institution that it deems too-big-to-fail. Ben Bernanke has noted that too-big-to-fail institutions are a growing problem in the U.S., especially for large interconnected financial institutions that make very large gambles. So what should be done about the too big to fail problem?

One solution thought to help with the too-big-to-fail problem, is to adopt a Canadian type banking system where banks are large, but not necessarily too interconnected. A fundamental difference between U.S. and Canadian banks is that in Canada, people are typically forced to post 20% of the purchase price of a new home, and also purchase insurance against the possibility of failure. But as Boone and Johnson point out, the government is providing the insurance to the banks in Canada. So, the question remains, what could be done about the banking system in the United States? Should we force banks into being smaller by breaking them up? Or should we allow very large financial institutions to exist as long as they maintain a greater level of capital against their loans (in other words, the government would limit the amount of leverage that banks are able to take).

19 thoughts on “GECON200-Topic #5: Too-Big-To-Fail”

  1. At this point in time with the economy that we are currently in, it is difficult to argue against the notion that some of the financial giants in the United States are indeed too big to fail. A small number of firms presently hold too much burden in the stability of the national and worldwide economies. Despite the size of the banking industry now, it is much smaller than it was in 1984. In fact, the number of banks has decreased 48% since then (1). Sustaining this trend filled with consolidations and mergers could continue to be detrimental to the economy. In order to right our economic ship, we must do two things to improve the stability and reliability of both large firms and smaller banks nationwide.

    First, we must enact and enforce regulations against participating in morally hazardous activities that we have seen in the wake of the government bailouts. Such policy would be similar to that in Britain after a recession of its own in 2008-2009 (2). If we do so, Bernanke’s “too big to fail” theory would no longer be quiet so gloomy. The government must pass laws strictly prohibiting excessively risky behavior on the part of large banking firms. If these regulations are disobeyed and the firm is in jeopardy of failing, the government could still bail them out. The ensuing situation would be similar to that of an individual suspected of committing a crime who is badly injured. The authorities allow the individual, in this case the bank, to get treatment, in the form of a bailout, until they are healthy and stable enough to face the charges of the crime committed. Although these policies do not eliminate the “too big to fail” theory, or the damage done by their actions, it does begin to hold banking firms accountable for their destructively risky decisions.

    The second change we must make concerns the leverage that these banking firms must uphold. The more leverage a firm holds, the more they are borrowing money in order to buy stocks or other assets According to economic author Karl Denninger, in 2004 the leverage limit of 12:1 (broker: dealer) on firms was removed by the Securities Exchange Commission. Since then, every major firm to go under (Bear Sterns, Lehman Brothers, Fannie Mae, Freddie Mac, and AIG) has had a leverage ratio much larger than 12:1. We must reinstitute the regulation of this leverage limit to require banks to buy assets with their own money and not on margin (3). Without it, there is little hope for increase morality in large scale decision making by large banking firms.

    (1) http://www.fdic.gov/bank/analytical/banking/2006jan/article2/index.html
    (2) http://paulflynnmp.typepad.com/my_weblog/2008/10/jail-the-bankers.html
    (3) http://www.denninger.net/letters/fixit.pdf

  2. “Too big to fail.” Seems pretty self-explanatory to me, as with Mr. Simon Johnson, of the NYT blog Economix, who says, “Make our largest banks small enough to fail. There is simply no other way to really end the problem of ‘too big to fail’” (1). Mr. Johnson explores the three camps proposed options to solve the TBTF issue.

    The first of these proposals is the Dodd bill, which seeks to expand the power of the FDIC to liquidate failing institutions. I feel that this is not the right course of action as the FDIC is completely unequipped by experience to handle the failure of a giant nonbank financial institution (2). The FDIC can handle the closure of small banks, but not necessarily a nonbank financial firm like Lehman Brothers, especially because the assets of these banks are not like the simple loans and residential and commercial mortgages small banks have. Finally, as Senator Shelby (R. AL) says, the Dodd bill “reinforces the expectation that the government stands ready to intervene on behalf of large and politically connected financial institutions at the expense of Main Street firms and the American taxpayer. Therefore, the bill institutionalizes ‘too big to fail.'” So, I’d like to cross this option off of the list.

    In contrast, though, Mr. Shelby’s counterproposal is to simply let these big banks fail. While, in theory, I could see how this might be helpful, it does not seem practical at all, and wouldn’t benefit the economy at present.

    My approach to solving the TBTF issue can be summed up with a quote from Alan Greenspan: “If they’re too big to fail, they’re too big.” Mr. Greenspan also brings up the example of Standard Oil Company. When the Standard Oil monopoly was broken up in 1911, its pieces became more valuable than the whole. Greenspan also argues that raising fees or capital on these big banks wouldn’t be enough, saying, “… they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll be using the savings” (3). Greenspan’s argument wins my approval even more because “arbitrarily breaking down organizations” goes against his own philosophical leanings, but he feels it is the best way to approach the issue. And, quite simply, I agree.

    (1) http://economix.blogs.nytimes.com/2010/04/08/ending-too-big-to-fail/?scp=1&sq=too%20big%20to%20fail&st=cse
    (2) http://online.wsj.com/article/SB10001424052702303493904575167571831270694.html
    (3) http://www.bloomberg.com/apps/news?pid=20601087&sid=aJ8HPmNUfchg

  3. Like a massive tree falling in a forest, the failure of huge mega-banks rip through the canopy and crush those new saplings, smaller banks and business, underneath their weight. The solution? Do not let the trees grow to such a monumental size. By letting banks such as JPMorgan, whose troubled asset ratio was 31.5 by 2009(1), grow to such large sizes we as a country gave them sound permission to do as they pleased; moral hazard could become a common practice because they were, simply put, too big to fail. These troubled asset ratios indicate stress put on banks by loans that are not being repaid on time; and as one can see, the troubled assets ratio for the five largest banks in America had risen by more than 20 points since 2007 (1). When large banks take risks and are rewarded with profits, other banks follow suit in order to keep up. In the same sense, when banks are saved, i.e. rewarded, for their risky behavior, others will, again, follow suit.

    We then face a dilemma; do we forcibly split banks into smaller sections or allow mega-banks to form? In my opinion, the first should be done and the latter avoided. Like most things, business and banks should have a growth limit in that, there is a point in their growth where they reach their “carrying capacity” of sorts and ride the line of failure by getting overconfident in their investment decisions. By bailing the banks out, the government of the United States may have allowed these large institutions to rise up over their growth limit again and it may backfire. Former IMF chief Simon Johnson states, “The process of saving them… has allowed them to build themselves up so that their balance sheets are now bigger than they were before the crisis” (2). Such mega-institutions carry too much weight of the economy on their shoulders as it is. It is as if the government is feeding hyper-obese people krispy kremes as if one more pastry will make things better; I disagree.

    Limiting the size of the banks and allowing smaller financial institutions to grow could more evenly distribute the pressure, lessening the need for high-risk investments to continue to grow. Thus, if one institution did fail, it would only be a minor bump in the road, rather than a sinkhole. Other institutions could pick up the dropped business and the void could be filled more easily. That is how capitalism works, “…the system gets cleaned out, the survivors deservingly pick up their failed rivals’ business and get richer…” (3). These large financial institutions are clogging the pipes of the American economy, breaking them down and limiting their size could potentially be the “turbo snake” we need to get things flowing once again (4).

    (1) http://www.msnbc.msn.com/id/29619236/
    (2) http://www.ibtimes.com/articles/18200/20100330/economist-johnson-urges-breakup-of-bigs-banks.htm
    (3) http://www.newsweek.com/id/184437
    (4) http://www.buytheturbosnake.com/Default.asp?bhcp=1

    1. wouldn’t limiting the size of investment banks actually limit the size of private investment and expand the role of public investment by the state?

  4. In the political arena there are two extreme solutions with regard to the TBTF idea. First, on the liberal end, the prevailing inclination is to regulate the banks in a way that eliminates the moral hazard of the state involving itself too heavily in government sponsored bailouts of the financial industry (1). This reasoning has serious momentum with the current Congress and Obama Administration. When crisis strikes in the financial banking sector, the immediate reaction of a liberal, hypothetically, is to downplay the seriousness of moral hazard in the short run and insure that the federal government does not let the banks file for bankruptcy. The logic in coming to this conclusion is most likely reached through an analysis of what the aftermath would hold for America if the banks actually did fail and what the immediate costs are. For the liberal, the moral hazards of allowing the economy to collapse outweigh the costs of using taxpayer money to save failing banks. For the far right conservative, the idea is that promises of future bailouts are part of the problem and that banks should be responsible for their actions. The moral hazard should not be overlooked in the short run.

    Is this analysis unreasonable? Is it possible that the liberal calculus has overlooked some other factors leading to bank failure? Harvard libertarian economist Jeffrey A. Miron seems to think that policies Congress pushed through starting in 1977 was the defining factor leading banks to make risky financial decisions with subprime lending (2, 3). Miron states, “Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.” Miron addresses the root of this problem not in current banking practices, but in bad policy enacted by Congress. It is an interesting point, but it seems that Miron places too much of the blame on Congress and not enough on top-down financial decisions.
    The jury is out on whether or not Mr. Miron is right. The data might correspond to his theory, but correlation does not always equal causation. If we were to get into the mind of highflying bankers, we might find that decisions on risky lending practices are almost always made in a tit-for-tat manner over time, or at the margin. So, how are we supposed to credit promises of bailouts to the reason risky decisions are made as a conservative would?

    Sources
    1. http://krugman.blogs.nytimes.com/2010/04/03/hijacking-too-big-to-fail/
    2. http://www.cnn.com/2008/POLITICS/09/29/miron.bailout/
    3. http://jumpinginpools.blogspot.com/2010/01/who-really-caused-banking-crisis.html

  5. “Too Big to Fail” once meant what it says. I propose that this not only still holds true but that it may ironically be the solution to the phrase’s more recently accepted definition and the problems therein. The American “Big Four”, Bank of America, JP Morgan Chase, Wells Fargo, and Citigroup, are all major economic forces who throughout the recession continued to if not thrive, then at least survive. JP Morgan, amidst a housing bubble crisis and the beginnings of the now infamous recession, was capable of fully purchasing the down and out investment firm of Bear Stearns (1). Wells Fargo was like-wise able to acquire Wachovia, which, at the time, was the fourth largest bank holding company in the United States (2 and 3). Together, these modern and massive financial institutions have proven themselves to be protected against economic calamities such as a recession. This attests to my point that “Too Big to Fail” is not as scary of a situation that people make it. Some of these institutions are literally too big to fail; however, there are smaller financial institutions that have much less of an impact on national and global economies. In the case of their own fiscal failures, they can be successfully absorbed into larger firms with more stability.

    Some may say that letting the smaller banks file under Chapter 11 would be a counterintuitive decision on behalf of the government. Should such a situation arise, an effective solution should both limit government intervention and simultaneously allow for the client base of small firms to emerge financially unscathed from failure, be it caused by an institution’s own decisions or by changes in the market. It has already been shown that larger, more stable companies are ready and willing to assimilate smaller ones, even in the wake of an economic downturn. If these kinds of purchasing decisions could be incentivized through tax breaks, then this would help keep these mergers based on American soil and benefit our economy more as a whole. The risk of oligopoly is intimidating, but the sense of security and stability that “Too Big to Fail” firms can provide is likewise necessary for continued growth in the post-recession economy. The “Big Four” provide the financial backing for the majority of America’s largest organizations and corporations. Larger firms, by nature of their sheer amount of assets, typically become more conservative in their investments. This is because they can draw a profit comparable or superior to their competition through investments with lower rates of return by investing more initial capital and through more varied investments.

    Sources:

    1) http://afp.google.com/article/ALeqM5hhH5aNzgHEUd6AQMcEn9RiSakK6A
    2) http://abcnews.go.com/Business/SmartHome/story?id=5946486&page=1
    3) https://www.wachovia.com/foundation/v/index.jsp?vgnextoid=557c10a2090aa110VgnVCM1000004b0d1872RCRD

  6. I believe that the answer to the “Too big to fail problem” lies in Senator Dodd’s proposal. He is trying to “to make sure the absence of information never leads to a financial crisis again.” (1) One of the big contributions to the financial crisis was the lack of knowledge regarding the backing of loans and the intertwined mortgages that existed. Nobody knew what was going on right up until the crisis and it caught us all by surprise. Many people didn’t know that their loans weren’t backed very well and the Fed didn’t realize the severity of the situation until hours before major firms were about to fail.

    So with Dodd’s proposal we will be able to have “living wills” in which the winding down of firms with more than $50 billion in assets will be planned out in detail so that neither a sudden bail out nor a sudden failure will occur. (2) This includes strengthening the Consumer Financial Products Bureau. This would help consumers understand the provisions behind loans and mortgages so that the blame and cause of things like sub prime mortgages and alt a mortgages aren’t placed on the lending institutions. The CFPB would protect consumers from hidden fees and deceptive practices and aid in the search for better mortgages, loans, and other financial products. (3) And let’s face it- the laziness that plagues most Americans almost mandates this clear and accurate break down of contracts and products.

    1. http://voices.washingtonpost.com/ezra-klein/2010/03/how_chris_dodds_finreg_proposa.html

    2. http://www.time.com/time/business/article/0,8599,1978531,00.html#ixzz0krP1576e

    3. http://www.creditcards.com/credit-card-news/senate-consumer-financial-protection-bureau-dodd-1282.php

  7. In the United States, too-big-to-fail institutions are a growing problem. Firms will behave immorally and take bigger risks, knowing that they have a plan b: the government will bail them out and pick up the pieces. If these firms are not managed soon they can lead the U.S. into future financial crises.

    I believe the first and biggest step to fix this banking problem would be to put a cap on the size of banks. In 1994, the top five banks together held 12% of U.S. deposits. Fifteen years later in 2009, the top five banks account for nearly 40% of all U.S. deposits. (1) Here is where the root of the problem lies. The more power a bank has, the more willing it is to take risks, therefore increasing the too-big-to-fail problem. If we can control the size of banks and decrease their power, maybe break them up into smaller pieces, the problem will lessen. One such recent step to change is from Senator Sherrod Brown of Ohio, who is looking to regulate the size of banks. “Brown’s amendment would prohibit banks from growing — either on their own or through acquisitions — to the point where their non-deposit liabilities (including off-balance sheet liabilities) amount to more than 3 percent of the country’s gross domestic product.” (2) And if banks happen to be over the limit, then tough luck. They’ll have to either shrink or put their assets somewhere else.

    The too-big-to-fail issue has gotten worse over the years and will become increasingly annoying if not stopped because it is almost as if the government is “rewarding” (for a lack of a better word) banks for bad behavior.

    Sources:
    1. http://www.newrules.org/banking/news/finally-bill-reinstate-limits-bank-size
    2. http://www.greenchange.org/article.php?id=5705

  8. To solve the problem of “too big to fail” there needs to be a plausible solution. As stated in “Canadian Banking is Not the Answer” having larger banks may not be that solution for the United States (1). So what will? Or what should?

    I think the best plausible solution should begin with banks making smarter decisions about who they lend their money to, and for what reasons. The issue of moral hazard in the United States is a big issue, especially concerning banks. Moral hazard encourages banks to make agreements knowing that it may not be in the borrowers’ best interest, or they take risks they know may easily fail (2). The United States may find a committee that overlooks banks, having more monitoring responsibilities than the FDIC, useful. Take Australia for example; it has the Australian Prudential Regulation Authority (APRA) which is relatively practical when overlooking banks making “[its] banking system is known as the most stable in the Asia-Pacific” (3).

    But why is Australia’s banking system so reliable and resilient? An analyst exploring the financial crisis took a look at banking systems around the world. Yes, Australia only had limited exposures to the financial turmoil, but besides this crisis, Australia has still remained strong. Compared to the United States, according to the analyst here are some reasons to why they remain strong: the lending standard has a different extent as riskier mortgages are not common(less incentive for higher-yielding loans), interest rates never dropped as low as the United States making borrowing when banks couldn’t pay back loans not so frequent, mortgages are considered “full recourse” meaning households can’t just hand over the keys to pay the debt, a stronger obligation is placed on responsible lending, and lastly, the APRA overlooks banks such as conducting several stress tests and strengthening the capital requirements for higher-risk housing loans (4).

    No, all these things cannot be duplicated to the United States banking system, but the one thing I feel could definitely be changed to help lessen the financial crisis and need for bailing out these “too big banks” is not allowing such weak borrowers to take out loans and taking less high-risks.

    (1) http://economix.blogs.nytimes.com/2010/03/25/canadian-banking-is-not-the-answer/
    (2) http://www.cato.org/pubs/journal/cj29n1/cj29n1-12.pdf
    (3) http://www.invest.vic.gov.au/Assets/860/1/Australia_Banking_System_Aug09.pdf
    (4) http://www.prefblog.com/?p=8012

  9. “If you want to understand the nature of a modern central bank, you have to study its history and relationship to commerce and government. (1)”

    The decentralized financial system under which our banks operate today was established in 1913 but between 1913 and 1791 when the First Bank of the United States was established, the central bank underwent many changes. After such a long period of trial and error, I do not believe the structure of the banking system is in need of further change. Instead the answer to the issue of banks that are considered “too-big-to-fail” is to implement more government control in the banks before they reach the point of desperately needing assistance.

    As an “independent entity within the government,” one of the primary responsibilities of the Fed is “supervising and regulating banking institutions” (2). During critical events of the past such as the Great Depression and World War II, the federal government assumed this responsibility by taking greater control of the fed (1). The government is not exercising enough control over the Fed today or else the risky, subprime loans that led to the demise of banks such as Bear Stearns and Lehman Brothers would never have passed inspection.

    When the economy is booming it is easy to accept the power of banks and trust them with such a significant amount of control over the nation’s wealth. Yet it is dangerous, as we have learned the hard way, to become overconfident and give the banks too much authority. The prosperous real estate market of the early 2000’s gave banks a false sense of security and immortality. As the old adage goes, “give a child an inch and he or she will take a mile,” banks have done just that. Since their main objective is to accumulate as much wealth as possible, they will take any risky measure necessary to achieve this goal. Therefore it is imperative that the Fed is present, as a mother, to review the daily decision making of these big investment banks. Simple tasks such as double checking the credit history of a prospective debtor and checking the bank’s balance sheets to ensure sufficient reserves and net wealth have the potential to prevent major problems. The time and cost that these extra efforts will impose on the Fed will be nothing compared to the huge costs to that economy that bank failures inflict.

    In conclusion, placing stricter requirements on the Fed to report to Congress will force the Fed to supervise the investment banks more closely so that they do not abuse their power and irresponsibly gamble with the public’s money. If the banks are regulated well, it is ok if they are “too-big-to-fail” because the risk of them failing will be significantly less.

    (1)http://www.minneapolisfed.org/community_education/student/centralbankhistory/bank.cfm
    (2)http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm

  10. JPMorgan Chase and Co. is now one of the so-called “too big to fail” financial institutions, but its history is similar to that of Bank of America and Wells Fargo, in that it started as a commercial bank attempting to turn a profit (1). The Manhattan Co., which grew to be the Chase Manhattan Bank, was in its early days a bank that used its excess capital to begin to turn a profit, financing such major projects as the city’s waterworks and the Erie Canal. In order to turn a profit, the banks, and today even these massive firms, require the investment of the people to do in essence anything. While they do have a seemingly unfathomable amount of wealth accumulated, it is solely based on the continuing investment and loan process. These firms aren’t “too big to fail;” rather, they’re too blindly trusted to fail. Should they begin to show cracks due to poor and risky investments, the government should point that out, not let them be swept under the rug until it suddenly becomes too late, and you’re begging for billions of dollars in bailout (lookin’ at you, Bank of America) (2).

    I’m not proposing an entire return to laissez faire policy, but what should be done is the Fed to dumb it down. The Fed should create a council that publishes regular reports on the actions taken by these economic supergiants, making nonbiased publications available and easily understood to the public. In this manner, people could choose to invest in systems that are renown for being, for example, riskier with greater profit, or safer with better guarantees, or what have you. Instead, we have the present system of names of banking industries that are known worldwide, but the transparency level of the status quo is “deliberately uninformative” (3). Should these firms begin to show cracks, it should be the Fed’s responsibility set up a giant flashing caution sign for all investors, both current and potential, so that the people can retrieve their assets if desired before all hell breaks loose. If the firm wants to maintain its profits, it needs to patch itself fast, reassure the investors, or else it should be allowed to fall, and fall hard.

    [1]www.jpmorgan.com/pdfdoc/jpmc/about/history/shorthistory.pdf+jp+morgan+origin&hl=en&gl=us&pid=bl&srcid=ADGEESjSE4fPR-a7G9SFnH7TnxWigkeKh4SEdZ_H-cBiiWeF5lzeROdvZfUd8jANsfWU_p9B34N4JC9UWkGZmm

    [2]http://www.nytimes.com/2009/01/15/business/15bank.html

    [3]http://blogs.reuters.com/felix-salmon/2009/08/11/annals-of-research-transparency-jp-morganmbia-edition/

  11. There seem to be two possible solutions to fix our financial system. The first would be to accept the Dodd bill. “Dodd’s plan would give new powers to the Federal Reserve to regulate the very largest financial institutions, including insurance companies, investment banks and commercial banks” (1). His plan would limit the risks that could be taken by these large banks and would force banks to keep a greater level of capital against their loans. However, some oppose the bill because they believe that, “the FDIC is completely unequipped by experience to handle the failure of a giant nonbank financial institution” (2). In addition, while capital requirements are important, they are simply not enough. Because capital requirements are enforced by regulatory agencies, which have the power to overlook shortfalls case by case, they can be an unreliable instrument during an economic boom, when regulators are infected by enthusiasm wafting in from the financial markets, if not by the more sinister problem of regulatory capture. In addition, there is the problem that capital requirements, like all complex calculations, can be gamed. (3). Lastly, Dodd’s bill would not end the “Too Big to Fail” problem because these large financial institutions would still too large.

    I believe that only way to fully solve the “Too big to fail” problem would be to break up the banks into smaller banks. “These large financial institutions should be dismantled before their risky behavior creates another financial and economic crisis” (4). In addition, larger banks are harder to supervise and manage and the benefits of risky behavior are outweighed by the costs. Larger banks must be cut down to a size where they no longer pose a threat to the financial system and the economy.

    (1) http://www.marketwatch.com/story/dodd-to-propose-limits-on-banks-risks-2010-03-15
    (2) http://online.wsj.com/article/SB10001424052702303493904575167571831270694.html
    (3) http://economix.blogs.nytimes.com/2010/04/01/capital-requirements-are-not-enough/
    (4) http://www.marketwatch.com/story/big-banks-should-be-broken-up-feds-fisher-says-2010-04-14

  12. While looking back on the recent financial crisis, I asked myself, “What determines if a bank is too big to fail?”

    Apparently Bernanke, Paulson and Geithner don’t even know the answer to that. By bailing out Bear Stearns (the smallest of the five large investment banks) and letting Lehman Brothers fail, how can we trust the government’s declaration of a bank’s TBTF status? Michael Heberling says that, “there are no clear guidelines on who is TBTF. As a result the “systemic risk” scare is ad hoc and apparently meant to be taken on faith“ (1).

    The problem of moral hazard is one that lies in the hands of both banks and the government. It is the banks’ responsibility to not assume that they are TBTF and it is the government’s responsibility to not bail out failing banks. If banks are labeled TBTF or they just assume they are, there is no downside to participating in extremely risky investments. Therefore the free market cannot be blamed for this financial crisis because it is the government’s safety net that led to the irresistible risks taken by large investment banks (1).

    Unfortunately, the TBTF precedent has already been set, and it will take quite awhile for that precedent to be reversed. There are reforms that must be made to the financial regulatory system. First of all, the ratings agencies that incorrectly labeled risky mortgage-backed securities as “AAA” either need to be stripped of their certification or otherwise reformed (2). The other big reform that needs to happen is strict leverage/capital rules. We must reinstate the 12-to-1-leverage rule (2). Last but not least, we need to stop bailing out failing companies. The TBTF label is dangerous to taxpayers (since we have to trust the government’s assessment of the systemic risk, which is usually not an objective opinion) and just increases the problem of moral hazard.

    (1) http://www.thefreemanonline.org/featured/too-big-to-fail/
    (2) http://www.ritholtz.com/blog/2010/03/on-to-financial-reform/

  13. “Even if you had broken Citigroup into 10 pieces, all of them would have gambled too much on the mortgage market.”(1)I think that former investment banker, Douglas Elliott, was correct in saying this. When creating legislation to help prevent another financial crisis, the focus should be taken off of the fear of the “too big to fail” firms and onto creating stricter regulations for institutions, no matter their size. If we only concentrate on breaking up big firms, we may still be at risk for a crisis that originates in smaller banks, like the crisis in the 1930s. (2) The problem is that banks are allowed to be too leveraged, meaning that they are allowed too much freedom in the practice of financing investments with borrowed funds. (2) In the past, there has also been a problem with “shadow banking”, which is when businesses put cash into overnight loans –to firms such as Lehman Brothers –which are not protected or regulated like other banking practices. (2) What we need is more regulation of banking practices. Previously, shadow banks operated with no safety nets and with minimal regulation, which has to change. (2) Also, in order for legislation, like the bill that has been proposed by Senator Chris Dodd, to be effective, there must be explicit rules for the banking system. The Dodd bill proposes the creation of a council that controls when to take over and shut down troubled firms. Some say that if there is no requirement for legislators on this council to shut down firms, then they will always take the easy way out, which is to bail them out. (1) This means that legislation must include something to force the actions of legislators. (3) Probably most importantly, there must be a maximum level for how much a bank can be leveraged. (3) Also, there must be regulations concerning when to seize troubled firms. (3) Overall, it is not about the size of the banks, but about the regulations that are put in place. In the cases of both big and small firms, if problems are handled incorrectly or ignored, a crisis can start. In the same way, if rules and regulations are put in place for all, future problems could be averted.
    1. http://www.time.com/time/business/article/0,8599,1978531,00.html
    2.http://www.nytimes.com/2010/04/02/opinion/02krugman.html?scp=2&sq=paul%20krugman%20AND%20financial%20reform&st=cse
    3.http://www.nytimes.com/2010/04/05/opinion/05krugman.html?scp=4&sq=paul%20krugman%20AND%20financial%20reform&st=cse

  14. The “too big to fail” problem has been a central part of the downfall of the US financial system. As implied by the name, the problem here is size. While some critics cite the interconnectedness, complexity, and internationality of the system as the core of the problem (1), I think that these factors only become a problem when the actual size of the bank becomes too large to control. The question thus presented then is, how do we go about solving this problem? I believe that a simple aggressive competitive system is a solution to the problem.

    Central to the competitiveness of our system is the fact that the “too big to fail” banks are able to exploit and monopolize the system by the simple fact that they are too big to fail and don’t have to worry about making risky calls. To encourage competitiveness and reduce this exploitation the state should require that every bank (especially these “big” banks) have a bankruptcy plan that would document and track their movements and exposures more carefully and in a timely manner. (1) There is no need to apply weaker conditions due to the recession, nor should it be applied specifically in some cases: this means that these banks that risk failure should not be given any special advantage over some smaller bank. (2)

    What then should be the approach of the state to encourage competition without discriminating towards these bigger banks that have developed? “While ‘real’ bailouts are needed, governments must avoid being ‘overly generous’ in bank rescues; this means in particular that, to the extent possible, bailout plans should wipe out initial equity holders, to reduce potential moral hazard.” (2) While bailouts for the time being may be a necessary evil, the government needs to be wary towards being overgenerous in its distribution. The very fact that they set the precedence that they will “save you” if you’re going under is largely what brought us to this point. Thus, looking beyond just the local interactions of banks, it should solely on the shoulders of the individual bank to determine its survival. (3) Through imposing a mandatory insolvency plan, this would force banks to take control of the records and prevent excessive risk taking.

    (1) http://blogs.ft.com/maverecon/2009/06/too-big-to-fail-is-too-big/
    (2) http://voxeu.org/index.php?q=node/4634
    (3) http://media.cfo.com/article.cfm/3000677?f=search

  15. The Federal Deposit Insurance Corporation (FDIC) was created by the Glass-Steagall act of 1933 as part of Roosevelt’s New Deal. This act was favored by “trust-busters” as it separated commercial and investment banking. Unfortunately, this enforcement gradually dismantled, and was finally repealed in 1999. The FDIC currently insures the deposits in member banks up to $250,000 per bank. They also examine and supervise certain financial institutions for safety, and functionality. Unfortunately, the government has allowed their involvement to get excessive, and as a result, banks enjoying deposit insurance and access to central bank funds are free to gamble with their depositors’ money; they are “banks with casinos attached to them” (1).The debate over whether we should “break-up” or “regulate” our banks is now more prevalent than ever, with the current financial and housing crisis we face.
    One proposed solution for the “too big to fail” banks, is President Obama’s plan for commercial banks to be forbidden to engage in proprietary trading, or trading on their own account, and from owning hedge funds and private-equity firms. They would be limited in their holding of derivative instruments, and no commercial bank would be advised to hold more than 10% of national deposits (2). The main idea of the Obama-Volker proposals is to reduce the risks that can be taken by any banking system that is backed by the federal government.
    The alternative approach is promoted by chairman of Britain’s Financial Service Authority, Adair Turner, seeks regulation to limit risk-taking without changing the structure of the banking system. New regulations would increase capital requirements, limit debt that banks could take on, and establish a Consumer Financial Protection Agency to protect naïve borrowers against predatory lending (2).
    Just how our priorities over the economy and the environment should be balanced, I believe that the banking issue should be tackled by compromise as well. We need to not necessarily break up the larger banks, but we do need to limit the amount of loans given out. One way to do this would be by requiring them to hold a certain amount or proportion of home mortgages. By holding more capital, and by paying higher regulatory fees, we can “penalize” a bank for being too big. Again, along with the environment issue, this is a world crisis as well, and we should actively work with other countries for solutions.
    Europe wants everyone to stick to the G20 reform which focuses on increasing capital requirements and leaving bank structures intact (3). This is simply because they are “preventing” a crisis, while the U.S. is trying to solve the current one that they face. This calls for an agreement on different levels. Britain, France, and Germany want to keep the universal bank model. “As long as local taxpayers are footing the bill, it’s going to be very hard to find global solutions that are unmatched with global tax capacity” (3). Obviously, this is going to be a difficult policy to agree upon, but once national resolution systems are in place, policymakers can see how they could work together to deal with cross-border failures.
    1. http://www.washingtonpost.com/wp-dyn/content/article/2009/08/27/AR2009082704193_3.html?sid=ST2009090801107
    2. http://www.sfbg.com/bruce/2010/02/19/robert-skidelsky-big-bank-fix
    3. http://www.saudigazette.com.sa/index.cfm?method=home.regcon&contentID=2010022864824

  16. Since I am on the tail end of most of the comments, I thought I might summarize and compare several major solutions suggested, in a streamlined fashion:

    So how do we prevent the problems of “too big to fail banks”—excessive “moral risks,” government bailouts, and returns to even bigger moral risks immediately after government bailout of these banks we just cannot allow to fail— from continuing and reoccurring?

    One proposal is to adopt the Canadian system of a few large, limitedly-connected banks that are supposedly regulated more strongly. While this system seems to work very well for the Canadians—“It is true that four of Canada’s major banks managed to earn a profit during 2008, all five were profitable in 2009, and none required an explicit taxpayer bailout…and in recent years there have been only two small bank failures in the entire country” (1)—it is not necessarily guaranteed to do so in the United States. In reality, Canadian banks are so assuredly backed up by the government—essentially they “originate mortgages, and then pass on the risk to government agencies” (1)—they take greater risks, make greater profits, and are safer because the government is already in place and ready to absorb mistakes. Other factors, such as greater “camaraderie among the regulators, the Bank of Canada and the individual banks” and a relationship with the political system that “prevent[s] banks from going wild,” also contribute to making the Canadian system work for the Canadians in a way I’m not sure we can reproduce in the United States (1). It seems like a sweet quick-solution, but beneath the sugar-coating of appearances, the full adoption of the Canadian system seems as risky as the risks it is trying to minimize.

    Another proposal is simply stricter or more diligent regulation of banks by the Fed and the central government. These regulations would supposedly take the place of the current bailout policy by allowing the government to keep fewer banks away from the brink and let some banks fail after making really, really stupid mistakes, while reducing the size and severity. However, could any of these proposed regulations work in a practical application? If two or more banks approach failure at the same time—“multiple threats are almost certain because each big bank races to copy any gambling technique that pays off big for any other” (2)—is the government really going to allow all those banks to fail, even with precautions to soften the blow? No, it will probably bail them out, and we are back where we started. Additionally, big banks are big players in politics; loopholes and lobbying are their specialties. They will lobby hard to get the regulations they want, but not necessarily what we need. As Robert Reich puts it: “As long as the big banks are allowed to remain big, their political leverage over Washington will remain big. And as long as their political leverage remains big, the taxpayer and economic tab for the next mess they create will be big” (2).

    So should we assiduously break big banks up into lots of little small banks? Some believe this would have an effect similar to diversifying: if one bank fails, the total impact isn’t too big a deal and the rest of the banks will happily pick up the slack. I’m not so sure. It’s hard to say, because I could not find very good sources on the effectiveness of small banks, but as Evan pointed out, “wouldn’t limiting the size of investment banks actually limit the size of private investment…?” Even if you spread investment across a very large number of small investment banks, I feel the individual limitations placed on each bank would limit the total productivity of the whole. Or think of it in terms of the saying “the sum of the parts is not equal to the value of the whole”…I’m not sure the capability of a large bank can be equally divided and apportioned to a comparable collection of smaller banks.

    It seems the only practical solution in this case is—as in many cases—the middle ground: we need to limit the size of banks. If banks are too large, they take great moral risks with little fear and bully the government into what serves them best whatever the outcome of their ventures. If banks are too small, our productivity could be limited. The happy medium is banks just large enough to be efficient—Reich claims “No one has been able to show significant efficiencies [when holding] over $100 billion in assets” so that could be an outer limit—but not large enough to bully the government or have “too big to fail” status and security. And while having a few banks might work with the Canadian political and economic system, it is within the nature of the system of the United States to need a fair number of banks; enough to allow for failures and pick up the slack reasonably well. Regulations for limiting the size would have to be specific, rigorous, and well enforced. So, in essence, the solution to the “too big to fail” problem isn’t so much one solution as it is a conglomeration and moderation of various approaches.

    1. http://economix.blogs.nytimes.com/2010/03/25/canadian-banking-is-not-the-answer/
    2. http://robertreich.org/post/498741821/break-up-the-banks

  17. People thinking that banks are too big to fail was a common misperception in the early 2000’s, but as we saw with the recent financial crisis that that is not the case and when the big banks fall they take out other financial institutions with them. But the answer isn’t to break up the big banks completely because they are vital to the international financial system. Congress notes this so some new regulatory measures were put into place. (1) The fed now has power over nonbank financial firms that have assets over 50 billion dollars and can break them up if they get in trouble. I feel like this is a major step in the right direction. I don’t believe that these firms need to be broken up but a higher body needs to be regulating they so they don’t take any excessive risks. We can do little things to make sure banks don’t take such risks. For example, in Canada if you take out a mortgage loan worth more than eighty percent of the value you have to get insurance on it. (2) This will ensure that banks get paid back on their riskier loans, hopefully preventing large-scale problems. Major government intervention into the financial sector also needs to stop because this creates moral hazard, encouraging banks to make riskier investments. If we can make these few adjustments I feel the financial sector will be much more stable.

    (1) http://www.reuters.com/article/idUSTRE62J0SM20100320
    (2) http://economix.blogs.nytimes.com/2010/03/25/canadian-banking-is-not-the-answer/

  18. Although the recent economic meltdown has spoken about the tremendous effects that supposedly “too big to fail” firms have on the market and economy, we should not rationalize that it was solely because of their size that caused the fall when they fell. There is no reason to limit the growth of a company if it were to grow continuously. Of course, if a company/firm can grow infinitely or at least have steady growth with sound principals behind their growth then why limit this. It would be unconstitutional to place a cap on the amount a company can grow (reference to Taylor Evan’s argument that government should limit growth of the “too big to fail” firms). We are not a socialists/communist nation where government has any authority whatsoever to tell people what to do and how much they can produce. Of course, complete “lassiez-faire” would not be the option either. The government should set regulations that would define “risky loans” and limit the number or percentage of risky loans that a company can make.
    This is evidence by the last housing bubble where loans made to consumers were way too risky. Firms like, Lehman Brothers and Bear Stearns, who were supposedly the “too-big-to fail” firms were able to offer theses risky loans because of their status in the market. They were able to eliminate competition. “If you are “too big to fail” (T.B.T.F.), credit markets see you as lower risk and as a more attractive investment — enabling you to obtain more financing on cheaper terms, and thus become even larger” (1). Their growth was speculative and when they realized that loans issued were higher than the current property value, they were left in a very deep hole.
    From this economic meltdown, we can learn that government must regulate such risky behavior, either by having regulations of asset/capital to liability ratio, or having a regulation of a set percentage for a down payment (15-20%) of a home, something that we had gone away from during the speculation period before the housing bubble burst. And also, greater liquidity value for firms should also be regulated. This is because, referencing the housing example, when we people began walking away from their houses knowing that the value of their houses had drastically decreased; the banks were left with the property. Obviously, houses don’t have great liquidity (2). Therefore, government should regulate or set a limit of value on liquidity and make sure that asset at least offset the liabilities.
    One thing I want to make clear, if not already stated implicitly, is that government should not bailout these companies. Not only does it create moral hazard, where other big firms begin making even riskier loans, assuming that the government will back them up, but citizens of America should not be responsible for faulty decisions by incompetent firms. We should not have to pay for these damages!!! Thus in the future, government should create regulations that would let banks fail, but when their failure happens, it would not come at the expense of the entire financial market. Next time, so be it. We are a free market, capitalistic system in nature, and we should act like it. Government needs to stick their hands in now and use reason not use rationalization and wait until it’s too late again.

    (1) – http://economix.blogs.nytimes.com/2010/04/08/ending-too-big-to-fail/
    (2) – http://www.prospect.org/cs/articles?article=the_myth_of_too_big_to_fail
    (3) – http://www.reuters.com/article/idUSTRE62J0SM20100320

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