On Tuesday of this week the Peterson Institute held a panel event devoted to the problem of financial institutions that are too big to fail. The panel consisted of Sheila Bair, Jon Huntsman, Simon Johnson, and Senator Sherrod Brown. The more I listened to the panel the more convinced I became that they were really missing the point, and in missing the point came to the wrong solution. Efforts to shrink financial institutions to a size where political leaders no longer feel compelled to bail them out are unlikely to be successful. A much better solution would be to amend the bankruptcy laws so that politicians have more confidence in their ability to handle large bankruptcies.
The common wisdom regarding too-big-to-fail institutions is that they are so important to the general economy that the failure of any one large bank would threaten the financial system and therefore the economy. As a result, regulators will always have to rescue the company’s creditors. However, this in turn will create moral hazard because both the financial institution and its creditors will feel free to engage in riskier behavior than they otherwise would. The solution proposed by all of the panelists is to penalize bigness.
I have no opinion on bigness. In the early 1990s officials in the first Bush Administration worried that large Japanese banks were eclipsing American ones and that the American banking industry was too fragmented. On the other hand, the trend in other industries has been away from large conglomerates because they were seldom able to achieve the efficiencies promised by their proponents. Absent regulatory intervention, I would expect many of today’s largest financial institutions to gradually sell off parts of their business as they face greater pressure from shareholders and the full costs of Dodd-Frank regulation became clear.
But I am fairly certain that government efforts to break up the banks are a poor solution. First, they assume that proponents of this strategy can obtain the political capital to accomplish it. This seems highly unlikely given that stronger language did not make it into the Dodd-Frank legislation and the difficulty regulators are having implementing the Volcker rule. Second, even if they had the statutory and Constitutional powers to force downsizing, I doubt regulators possess the detailed knowledge of markets and institutions to do in wisely. Especially in finance, the market is too complex and evolves too quickly. Most of all, however, bigness is not really the issue.
During the panel discussion, Sen. Brown mentioned his support of the auto bailout in which the government intervened in the bankruptcy of General Motors and Chrysler. The bailout was financed by a highly strained interpretation of the authority given to the Administration under the Troubled Asset Relief Program (TARP) and accounted for most of the taxpayer losses under it. The central arguments for government intervention were the same for GM and Chrysler as they were for the financial institutions: that the consequences of bankruptcy to the broader economy were too great to let these companies go through the normal bankruptcy process. In this case the number of jobs lost and the interconnectedness of the supplier network were often mentioned. Similar arguments might someday be made if other companies such as Boeing get in trouble. And yet no one is talking about breaking these companies up. So I question whether bigness is the real issue.
The real problem is that, when push comes to shove, political leaders often face tremendous pressure to mitigate the fallout from large firms. The current emphasis is on financial institutions because they started the crisis. But similar concerns surround any large company that has a large number of employees, counter parties, suppliers, and customers. Political pressure is part of the problem, but so is a genuine uncertainty about the ability of normal bankruptcy laws to handle large and complex organizations, especially in the absence of a clear buyer with bridge financing. If this is the problem, then the solution is to improve the bankruptcy laws. Dodd-Frank addressed this problem by requiring companies to prepare living wills and giving the FDIC enhanced powers to liquidate an insolvent financial institution but these solutions are unlikely to work in practice. The plans are unlikely to be sufficiently detailed to help in a crisis and there are serious problems with giving politically appointed regulators the broad powers needed to handle such a crisis successfully.
A better solution would be to deal with the problem directly by amending the bankruptcy code to give the bankruptcy judge and the trustee the necessary powers, many of which are now given to FDIC under Title II of Dodd-Frank. The Pew Financial Reform Project Task Force, which I worked with at the Pew Charitable Trusts did make such a proposal. The Task Force called for the designation of a special bankruptcy court to handle all financial bankruptcies. This designation would reduce the uncertainty about which court would oversee a filing and allow the selection of the judge and trustee most skilled in financial matters. Reliance on bankruptcy would remove political considerations from any liquidation and provide greater certainty to both creditors and potential investors. If one proceeds from the premise that politicians usually do not want to bail out failed institutions (not always true) then giving bankruptcy courts the specific powers needed to enable them to handle large financial institutions would make the most sense.
A few scholars including John Taylor have been working on such a proposal but Congress seems to have no interest in acting on it. Luckily the public is so strongly against the TARP legislation that another bailout is unlikely.