Too big to fail, it appears, may be too big to solve.
Connecticut Senator Christopher Dodd's recently proposed financial-reform bill creates a team of regulators with the authority to shut down troubled institutions. It calls for capital and liquidity requirements. It obligates banks to fund a $50 billion bailout fund as well as draft so-called living wills detailed plans drawn up in advance of how firms should be shut down if they run into trouble.
Yet policy experts and economists from both ends of the political spectrum say the bill does little to end the problem of banks' becoming so big that the government is forced to bail them out when they stumble. Some say the proposed financial reform may even make the problem worse.
"Too big to fail is opposed by the right and the left, though not apparently by the people drafting legislation," says Simon Johnson, an MIT professor and the author of a recently published book on the subject, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. "The current financial-reform bills are effectively a wash on the issue."
The question is how large banks ought to be allowed to become. When large banks run into trouble, regulators are often unwilling to let them fail, as bank failures can wipe out individual depositors. What's more, banks often fund their operations by borrowing from other banks. The bigger the bank, the more likely it is to put other banks at risk if it fails. Mass bank failures, especially of big banks, means people can't get loans. And no loans, no economy.
That's why the government decided to bail out most of the nation's largest banks at the height of the financial crisis. And here's where the problem potentially gets worse. Once bankers understand that the government will bail out their firms when their loans or other financial bets go bad, they are likely to take riskier and riskier bets. That, of course, leads to more potential bank failures and more taxpayer-funded bailouts.
The Dodd bill was supposed to end all of this, and Dodd says it does. Nonetheless, policymakers and economists say it's far from clear that the proposed legislation solves the matter. Even members of the Federal Reserve, which gets a lot more power to regulate banks and financial products under the Dodd bill, are wary of the proposal's ability to end too big to fail. Richmond Federal Reserve president Jeffrey Lacker recently said on CNBC that he believes the bill does little to stop future financial bailouts.
"When you talk to foreign regulators, they tell you they are very surprised at how far behind American officials are on what needs to be done to end the problem," says Rob Johnson, director of the Project on Global Finance at the Roosevelt Institute. "The British are doing a substantially better job of it."
The problem, according to former investment banker and Brookings fellow Douglas Elliott, is that Dodd's financial-reform bill gives regulators the ability to take over and shut down large troubled financial institutions before they become a problem to the economy, but it does not require them to do so. Elliott says the bill leaves the question of when to execute resolution authority up to regulators. And as in 2008, he thinks future regulators will be unwilling to make the decision to close a bank. "Regulators are always going to go for the easy solution, which is bailout," says Elliott.
Alex Pollock of the American Enterprise Institute (AEI) says there is potential for the Dodd bill to make the problem even worse. Pollock contends that designating one group of banks as having to pay into the resolution fund will implicitly label those banks as too big to fail. "Supporters of this bill say it creates special government authority to take care of the problem of troubled banks," says Pollock. "But I think many bankers will read the regulations to mean that the government now has to take care of them." Peter Wallison, also of the AEI, says large banks will be seen as safer to deal with since they will be deemed protected by the government. That will cause more individuals and companies to put their money into large banks, making the biggest banks even bigger.
Johnson and Elliott, though, say there is little evidence that the Dodd bill will make things worse. It's no secret, they point out, which banks are America's biggest and most important, and therefore the ones most likely to have to pay into the fund. Elliott says the Dodd proposal is at least a step in the right direction. By giving regulators the authority to wind down large banks and a $50 billion fund, paid for by the banks, to do so you lower, though not eliminate, the possibility of future taxpayer-funded bailouts.
What's more, Elliott argues that some of the focus on large firms as the economy's Achilles' heel may be misguided. The problem in this crisis was not that the firms were too big, he says, but that all banks were more leveraged than they should have been. And Elliott believes the Dodd bill will, in general, make the market less risky. "Even if you had broken Citigroup into 10 pieces, all of them would have gambled too much on the mortgage market," says Elliott.