Government

Still Too Big To Fail? (Part I)

Note: This is the first of two related posts

In his latest New York Times Magazine column, Adam Davidson writes, "Failure is as important to healthy capitalism as success. The nation's handful of huge banks, however, are spared the indignity of failure."

To continue the discussion, we asked two economists on different sides of the debate — Phillip Swagel of University of Maryland and the American Enterprise Institute and Simon Johnson of MIT — to answer the following question:

Do the "big four" U.S. banks stifle competition and innovation?

Phillip Swagel's answer is below; To read Simon Johnson's answer, click here.

Financial firms come in for lots of criticism these days, with big banks perhaps the least loved denizens of Wall Street. Many Americans resent banks' roles in the financial crisis and in home foreclosures, and are angered at huge salaries paid by firms that received taxpayer money.

These feelings are understandable, but not the entire picture. While large banks contributed to the crisis, the problems with subprime lending were mainly in less-regulated non-bank mortgage lenders. The government-sponsored enterprises of Fannie Mae and Freddie Mac played important roles in the crisis as well. Most big banks have repaid their federal support with a healthy return for taxpayers.

Finally, it might be unfashionable to state it, but big banks contribute to the economy and to society, including by helping large multinational corporations (also oft-criticized but vital) manage their day-to-day finances and guard against financial risks in ways that smaller banks cannot do as well. Large banks help firms of all sizes to expand, invest in plants and equipment, buy supplies, and create jobs.

The passage of the 2010 Dodd-Frank financial regulatory law will have profound effects on large banks. The act itself is a mixed bag. Some provisions will help regulators detect market problems and ensure that firms have increased capital and more stable funding to withstand market strains. But these new powers go largely to the same regulators who did not avoid the last crisis and the added capital requirements are likely to translate into reduced lending and thus a less vibrant economy.

Dodd-Frank did not seek to break up large banks — to the dismay of many on both sides of the political aisle. But less well understood is that provisions in Dodd-Frank do help address the concern that some institutions are "too big to fail." The government has long been able to take over a failing bank. New rules in Dodd-Frank extend this to the larger financial holding companies that combine under one corporate roof — not just banks but also broker-dealers, investment banks, and insurance companies.

The new authority allows the government to step in if a firm's failure threatens the stability of U.S. financial markets. Taxpayer money can be used to keep a firm afloat temporarily while the government figures out how to wind down the business. Shareholders will be wiped out, but this happened already at Lehman Brothers, while the owners of troubled firms such as Bear Stearns, AIG, and Citigroup took huge hits even if they walked away with something.

What is new is that bondholders—the people who lent the money to firms that got into trouble—will now expect to take a loss when a firm fails. This is because under Dodd-Frank any losses incurred by the government will be clawed back from bondholders after the fact (and then from competitors if needed). Investors can no longer blithely lend money to large banks under the assumption that the government will be forced to pay them back to avoid financial calamity.

It is hard to know how this will be done in practice—the act says it should be "orderly" but that could be a tall order in the face of the next crisis. And Dodd-Frank leaves a worrisome amount of discretion to government officials, who could look to circumvent the Congressional control of the purse strings by ordering firms in government hands to spend money for policy purposes (as the Obama administration did by having GM and Chrysler transfer billions of TARP dollars to political allies).

Even so, it is a huge regime change to put investors on notice that firms of all sizes can be allowed to fail and that taxpayer money is not available to make investors whole. The new financial regulatory regime is not the end of large banks — indeed, that would harm the economy. But it is a step toward addressing the concern that some of them are too big to fail.

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