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Preventative Measures

Have we finally fixed the 'too big to fail' problem?

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Last night the Senate approved a major financial reform bill almost a year in the making. A few hours before the vote, the president hailed the legislation, which he said ensures that “the American people will never again be asked to foot the bill for Wall Street’s mistakes.” He elaborated: 

There will be no more taxpayer-funded bailouts--period. If a large financial institution should ever fail, we will have the tools to wind it down without endangering the broader economy. And there will be new rules to prevent financial institutions from becoming “too big to fail” in the first place, so that we don’t have another AIG.

But is this really true? Does the financial reform bill really solve the problem of “too big to fail”? The answer is: “Sorta,” but not quite in the way the bill’s supporters suggest.

The gist of the administration’s attack on the too-big-to-fail (TBTF) problem is a provision known as “resolution authority.” Under the status quo, the government basically has two choices for dealing with a major financial firm on the brink of collapse: It can get out of the way and hope for the best, as it did to disastrous effect with Lehman Brothers. Or the Federal Reserve can float the company a massive loan, as in the case of AIG.

The idea behind resolution authority is to avoid these lousy choices. Under the new law, the government would be able seize the wobbly firm, fire its executives, and fund its operations until it could sell them off in pieces. The proceeds from these sales would pay the government back; whatever was left would go to bondholders, who would presumably suffer some losses. The shareholders—the people who own common stock—would get wiped out entirely. (If the proceeds weren’t enough to repay the government, it would recoup the rest by levying a fee on the industry.) This is basically a scaled up (and stretched out) version of the way the FDIC handles smaller-bank failures.

Long story short, resolution authority is unquestionably an improvement over the status quo. The biggest reason is that the prospect of losses for bondholders mitigates the most pernicious consequence of TBTF: moral hazard. That is, because people who lend money to megabanks assume the government will make them whole if the bank collapses, the lenders have little incentive to rein in excessive risk-taking by the bank’s managers. In fact, they actually encourage it by under-pricing their loans. The threat of being “resolved” by the government should change that calculus.

That’s how it’s supposed to work, in any case. In practice, there are a number of complications. For one thing, it’s not clear that bondholders actually will suffer losses in the end, at least not all or even most of them. The government isn’t likely to impose losses when it first takes over a failing megabank because doing so in the middle of a financial crisis—and you're almost by definition in a crisis if a megabank is failing—risks accelerating the panic. (Investors might refuse to roll over their loans to other troubled companies for fear of suffering similar losses.) And if the government waits to impose losses until it’s done liquidating the company—a process that could stretch for years—the short-term bondholders will have long since taken their money and run. So, at the very least, the people who lend short-term can probably count on being bailed out, which encourages companies to fund themselves with short-term debt, which is the least stable form of funding.

And there are other potential problems. First, the new law only extends to U.S. companies, while most megabanks have an international footing. It’s not clear what happens to the overseas operations of American companies while their U.S. assets are in receivership. In the case of AIG, the Fed loan kept the overseas affiliates solvent. But Congress is on the verge of explicitly preventing the Fed from extending such a loan in the future. The upshot could be chaos. For example, U.S. creditors might have to take big, upfront losses to make bondholders in overseas subsidiaries whole. That would worsen the panic at home for the reasons described above (and could eventually force Congress to step in with a bailout). All of which is to say that, while resolution authority is clearly a step in the right direction, it raises almost as many questions as it answers.

The good news is that resolution authority isn’t the only way to deal with the problem of too big to fail. Congress could simply break up the banks, for example. Alternatively, if you think of “bigness” as an externality—which is to say, something we get too much of because, like pollution or unhealthy eating, it imposes a social cost that the producer doesn’t entirely pay—then you can discourage it through taxation. (In economist-speak, this would force the banks to internalize the true social cost of their size.) One way to do this would have been to simply impose a tax on the biggest banks, which even conservative economists like Harvard’s Greg Mankiw support. Another way would be to impose stricter limits on leverage for the largest banks—that is, the amount of debt banks can take on relative to equity. Because banks earn more profits when they’re more leveraged (just like you make a larger profit, percentage-wise, when you flip a house on which you put down 5 percent versus 10 percent), this is similar to a tax on bigness.


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