Regulating and Resolving Institutions Considered “Too Big to Fail”

Regulating and Resolving Institutions Considered “Too Big to Fail”. By Martin Neil Baily & Robert E. Litan
Testimony, Senate Committee on Banking, Housing and Urban Affairs
May 06, 2009

Thank you Mr. Chairman and members of the Committee for asking us to discuss with you the appropriate policy response to what has come to be widely known as the “too big to fail” (TBTF) problem. We will first outline some threshold thoughts on this question and then answer the questions that you posed in requesting this testimony.

The Key Points

Too Big to Fail and the Current Financial Crisis

• The US economy has been in free fall. Hopefully the pace of decline is now easing, but the transition to sustained growth will not be possible without a restoration of the financial sector to health.
• The largest US financial institutions hold most of the financial assets and liabilities of the sector as a whole and, despite encouraging signs, many of them remain very fragile.
• Many banks in the UK, Ireland, Switzerland, Austria, Germany, Spain and Greece are troubled and there is no European counterpart to the US Treasury to stand behind them. The global financial sector is in a very precarious state.
• In this situation policymakers must deal with “too big to fail” institutions because we cannot afford to see the disorderly failure of another major financial institution, which would exacerbate systemic risk and threaten economic recovery.
• The stress tests are being completed and some banks will be told to raise or take additional capital. There is a lot more to be done after this, however, as large volumes of troubled or toxic assets remain on the books and more such assets are being created as the recession continues.
• It is possible that one or two of the very large banks will become irretrievably insolvent and must be taken over by the authorities and, if so, they will have to deal with that problem even though the cost to taxpayers will be high. But pre-emptive nationalization of the large banks is a terrible idea on policy grounds and is clouded by thicket of legal problems.
• Getting the US financial sector up and running again is essential, but will be very expensive and is deeply unpopular. If Americans want a growing economy next year with an improving labor market, Congress will have to bite the bullet and provide more Treasury TARP funds, maybe on a large scale. The costs to taxpayers and the country will be lower than nationalizing the banks.
• Congress recently removed from the President’s budget the funds to expand the TARP, a move that can only deepen the recession and delay the recovery.

Too Big to Fail: Answering the Four Key Questions (Plus One More)

• Should regulation prevent financial institutions from becoming too big to fail? We need very large financial institutions given the scale of the global capital markets and, of necessity, some of these may be "too big to fail" (TBTF) because of systemic risks. For US institutions to operate in global capital markets, they will need to be large. Congress should not punish or prevent organic growth that may result in an institution having TBTF status.
• At the same time, however, TBTF institutions can be regulated in a way that at least partially offsets the risks they pose to the rest of the financial system by virtue of their potential TBTF status. Capital standards for large banks should be raised progressively as they increase in size, for example. In addition, financial regulators should have the ability to prevent a financial merger on the grounds that it would unduly increase systemic risk (this judgment would be separate from the traditional competition analysis that is conducted by the Department of Justice’s Antitrust Division).
  
• Should Existing Institutions be Broken Up? Organic growth should not be discouraged since it is a vital part of improving efficiency. If, however, the FDIC (or another resolution authority) assumes control of a weakened TBTF financial institution and later returns it to the private sector, the agency should operate under a presumption that it break the institution into pieces that are not considered TBTF. And it should also avoid selling any one of the pieces to an acquirer that will create a new TBTF institution. The presumption could be overcome, however, if the agency determines that the costs of breakup would be large or the immediate need to avoid systemic consequences requires an immediate sale to another large institution.
• What Requirements Should be Imposed on Too Big to Fail Institutions? TBTF or systemically important financial institutions (SIFIs) can and should be specially regulated, ideally by a single systemic risk regulator. This is a challenging task, as we discuss further below, but we believe it is both one that can be met and is clearly necessary in light of recent events.
• Too big to fail institutions have an advantage in that their cost of capital is lower than that of small institutions. At a recent Brookings meeting, Alan Greenspan estimated informally that TBTF banks can borrow at lower cost than other banks, a cost advantage of 50 basis points. This means that some degree of additional regulatory costs (in the form of higher capital requirements, for example) can be imposed on large financial institutions without rendering them uncompetitive.
  
• Improved Resolution Procedures for Systemically Important Banks. This is an important issue that should be addressed soon. When large financial firms become distressed, it is difficult to restructure them as ongoing institutions and governments end up spending large amounts to support the financial sector, just as is happening now. The Squam Lake Working group has proposed one solution to this problem: that systemically important banks (and other financial institutions) be required to issue a long-term debt instrument that converts to equity under specific conditions. Institutions would issue these bonds before a crisis and, if triggered, the automatic conversion of debt into equity would transform an undercapitalized or insolvent institution, at least in principle, into a well capitalized one at no cost to taxpayers.
• Where the losses are so severe that they deplete even the newly converted capital, there should be a bank-like process for orderly resolving the institution by placing it in receivership. Treasury Secretary Geithner has outlined a process for doing this, which we generally support. There are other important resolution-related issues that must be addressed and we discuss them below.
  
• The Origin of the Crisis and the Structure of the Solution. The financial crisis was the result of market failure and regulatory failure. Market failure occurred because wealth-holders in many cases failed to take the most rudimentary precautions to protect their own interests. Compensation structures were established in companies that rewarded excessive risk taking. Banks bought mortgages knowing that lending standards had become lax.
• At the same time, there were thousands of regulators who were supposed to be watching the store, literally rooms full of regulators policing the large institutions. Warnings were given to regulators of impending crisis but they chose to ignore them, believing instead that the market could regulate itself.
• In the future we must seek a system that takes advantage of market incentives and makes use of well-paid highly-qualified regulators. Creating such a system will take time and commitment, but it is clearly necessary.

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