TOO BIG to fail

Northwestern Financial Review, Sep 15-Sep 30, 2004 by Whitlock, Robert B

During the relatively placid banking years of the last decade or so, the debate over "too big to fail" has become so muted that one might think the problem has been solved by both the strength of the banking industry and the limiting statutory provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991.

Not so, say Gary H. Stern and Ron J. Feldman, the President and a Vice President of the Federal Reserve Bank of Minneapolis. In a slim volume, Too Big to Fail: The Hazards of Bank Bailouts (148 pages of text plus 4 appendices, Brookings Institution Press, Washington, D.C., 2004, $37.00), the authors set forth the history of, their analysis of the present status of, and recommendations for future regulatory and political reaction to "TBTF."

A bank is said to be too big to fail if the failure of the bank would cause, in the judgment of regulators and political officials, a probability of systemic failure of the banking and financial system of a country by creating a spillover effect whereby creditors of other banks would cause runs on the banks, and a disruption in the payment and other financial systems would occur. In such cases, national governments (not only the United States) have provided cash and credits to creditors of the failing bank to maintain or restore confidence in the financial system. In the United States, the payments to uninsured creditors are paid mostly with funds provided by the Federal Deposit Insurance Corporation from insurance premiums which have been paid on other insured deposits.

The authors criticize these payments and the relative certainty of them for creating situations in which a bank's creditors do not critically analyze a bank's financial condition prior to extending credit, assuming that the risk of non-repayment is relatively low. In the eyes of the creditor, the bank is too big to fail and the government will come to its rescue. This, in turn, sets up the moral hazard that a bank which is in failing or near failing condition may take irrational risks to save the bank, instead succeeding in digging its grave deeper by taking more and more deposits and increasing the ultimate cost of its resolution. This was the situation in the savings and loan crisis between 1985 and 1992.

Although governments do not publish lists of the banks which are too big to fail, and indeed the identity of such banks is not determined until the moment of crisis, sophisticated depositors can look at the largest institutions in a country or those with a highly specialized activity in the payment system as being logical candidates for governmental largesse. The continuing combination of super-large banks creates both the perceived need for and increased expense of too-big-to-fail treatment.

Apart from the uncompensated use of deposit insurance dollars, what difference does this make to the average community banker? The existence of TBTF has troubled thoughtful community bankers for years. Yes, the use of FDI paid premiums to pay off creditors for which no premiums have been collected is troubling. But even more troubling on a day-in, day-out competitive basis is the fact that depositors capable of generating deposits greater than the insured amount will pass by a well capitalized and well managed community bank in favor of a bank surmised to be too big to fail. Thus, a potential source of deposits for community growth is given to a distant money-center bank, with implicit government support.

The authors describe the attempted remedy imposed by the Federal Deposit Insurance Corporation Improvement Act of 1991. That Act first of all requires the FDIC to resolve failed bank cases on a least-cost basis. However, if a failing bank's creditors are thought to need payment for uninsured credit to prevent a spillover effect, the Act sets up an obstacle course which must be run before TBTF can take effect. The approval of two-thirds of the boards of both the Federal Reserve and FDIC must be obtained following a determination by the secretary of Treasury that the leastcost method would create systemic problems, after which the Treasury secretary must consult with the President of the United States. The FDIC would then impose special assessments on all banks to replenish its funds.

The authors point out that in addition to the relative calm of the banking industry over the last short period of time, many observers think that the hoops created by the Act have imposed some market discipline and solved the problem. Bank creditors which may, before the Act, have taken the risk of a bank debtor's failure lightly if the bank was considered too big to fail may now consider the difficulties of a bailout and price and extend credit accordingly. The authors point out, however, that in times of crisis the political winds blow strong, and we now have policymakers and regulators who have not been tested in the crucible of an impending big bank failure.

They anticipate that when confronted, those in authority will do pretty much as those previously in such positions - bow to pressures and provide government assistance. The authors' remedies for this are to instill more hoops to jump through and appoint (elect?) strong regulators and policymakers who are totally committed to TBTF as only a very last resort. Failing this, they suggest, TBTF will remain a problem, the significance of which will only be known on the fateful day of the failure of a TBTF bank.