A Back Door Way of Addressing Too-Big-To-Fail

Commentary by Robert Litan, Jan. 17 (Bloomberg) — One of the aftershocks of the financial crisis — even among those who supported the federal rescues — was the widespread revulsion about the need to rescue the creditors of “too-big-to-fail” (TBTF) banks and other large financial institutions.

     The Dodd-Frank Act included a number of measures aimed at correcting the problem. Banks must have “living wills” approved by regulators to make them easier to handle if they fail. The FDIC has new authority to wind down large non-banking financial institutions in a way that makes creditors share in the pain of loss. Large “systemically important financial institutions” — those thought to be TBTF — eventually must have larger capital cushions than their smaller competitors.   

      A number of academic scholars and elected officials from both political parties want to go further: they want to break up the largest banks, not as a penalty for failing to provide an adequate living will (the current law), but simply because they are big.

      Although I am sympathetic with the motivations of the critics who say very large banks are too complex to manage, and dangerous to the economy if they fail, I always have been troubled by the absence of any defensible standard for defining what asset threshold to use to cut them down to size. Moreover, I fear that whatever asset ceiling is picked, institutions just under the limit will find off-balance sheet ways to take risks that could make them just as interconnected and systemically important as they are now.

      To top it all off, I have yet to be convinced that a banking system composed of, say, 10 or 15 banks of $250 billion in size (to pick a number) is safer or less prone to instability than a system of four large banks each with $1 trillion or more in assets. Once uninsured creditors begin running on one or two of the smaller $250 billion banks, creditors at other similarly sized banks with similar solvency problems – as is often the case when one or two large banks get into trouble – will be tempted to run, too. In the end, the Fed and the FDIC may end up protecting uninsured creditors at all of the “medium size” banks, treating them TBTF in the process.

      In a new Bloomberg Government study, senior economic analyst Christopher Payne describes and questions yet another attempt by federal regulators, the Federal Reserve in particular, to rein in TBTF banks. This “back door” approach has a technocratic name- – “counterparty credit exposure limit” — but in reality it’s quite straightforward.

      One of the Fed’s main worries about the largest financial institutions is their interconnection to each other, the idea being that if one or more of them go down, they could drag others with them because each of them owes money to other. The Fed wants to cap these “counterparty ” risks by proposing a limit on the credit exposures of banks to each other, not just loans, but also their exposures via the “derivatives market” — mainly “swap” contracts in which banks act as brokers for other parties or are parties themselves to contracts in which they owe money to other banks.

      One cap proposed by the Fed is not that controversial: All banks with assets between $50 billion and $500 billion must limit their counterparty exposures to other individual institutions to 25 percent of the bank’s shareholder’s money, or “capital” in regulatory jargon, plus the bank’s loan loss reserve. The most controversial proposal, however, would lower that cap to just 10 percent of capital (and loan loss reserve) for all banks over the $500 billion threshold, or roughly the 5 largest.

      Payne provides an illustrative calculation indicating that this second aspect of the rule may force the largest banks to cut their derivatives activities with each other, in the aggregate, by about 20 percent. This may not sound like a lot, but when you consider that derivatives activities account for a sizeable share of some banks’ revenue and profits, it is a sizeable haircut. The backdoor rationale: this is one, admittedly indirect, way of limiting large bank size and spreading the derivatives activities around to smaller banks, including foreign banks.

      Since I have written elsewhere that the derivatives market is highly concentrated – almost a “club” – the de-concentrating impact of the Fed’s proposed limits is a good thing. The same holds, at least in principle, for its potential to limit large TBTF bank size.

      Payne, however, raises two useful cautions. One is that the proposed methods for calculating the counterparty exposures from derivatives contracts considerably overstate the true exposures in ways that are not economically defensible. The Fed’s techniques might not even hold in court should they be challenged (another recent Bloomberg Government Study, by senior finance policy analyst Cady North, found that some Dodd-Frank rules are now being challenged in court).

      Equally problematic is the unknown impact of perhaps arbitrarily dispersing derivatives activities among many banks that so far don’t have large market shares. Payne warns that neither the Fed nor anyone else knows how much the proposed limits on the largest banks will reduce liquidity in derivatives markets, which are important for financial institutions and other users to hedge their risks. Reduced liquidity could lead to higher trading costs and make the financial system more prone to collapse under stress — precisely what regulators are trying to avoid.

      The bottom line: TBTF is a tough public policy challenge to address in the right way without the law of unintended consequences making the situation worse. Arbitrary size limits are problematic; so are arbitrary, less-direct means of cutting large banks down to size.




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