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Is “Too-Big-to-Fail” Still With Us? Yes, It’s Hiding in Plain Sight

Dickinson School of Law Pennsylvania State University University Park PA April 11, 2014 Harvey Rosenblum Professor of Financial Practice Southern Methodist University Cox School of Business

Is “Too-Big-to-Fail” Still With Us? Yes, It’s Hiding in Plain Sight*

Dickinson School of Law Pennsylvania State University University Park PA April 11, 2014

Harvey Rosenblum Professor of Financial Practice Cox School of Business Southern Methodist University

*Adapted from my testimony: “Ending Too-Big-to-Fail Subsidies: Incentives Really Matter,” before the United States Senate, Subcommittee

• n Financial Institutions and Consumer Protection; Committee on

Banking, Housing and Urban Affairs, Washington, D.C., January 8, 2014

Some Basic Principles

• If you want less of something, tax it
• If you want more, subsidize it
• A subsidy is simply a negative tax
• Regulation is another name for a tax
• The imposition of taxes and subsidies is a

role of the U.S. Congress

• If we wish to end “Too-Big-to-Fail,” we

definitely should not subsidize it

The Too-Big-to-Fail Subsidy

• Huge: $50-100 Billion annually
• In perpetuity
• Distorts market forces
• Never approved by Congress
• Not illegal, but economically inconsistent

with U.S. constitutional principles

• Transfer from taxpayers to BHC

stakeholders, mainly top management and creditors

Before a Law School Audience

• Need to distinguish between
• Strictly illegal behaviors

vs.

• Behaviors that are reprehensible,

unconscionable or ethically questionable

• We live in a civilized society where we do

not necessarily condone all behaviors that are not explicitly prohibited under existing legal statutes

Market Forces Work When

• Proper incentives
• Competition
• Management responsive to shareholder

interests

• No companies are either too big (or

important) to prosecute These pre-requisites violated by giant banking institutions

U.S. Banking Industry Concentration

52 32 16

2010

17 37 46

1970

12,500 smaller banks 5,700 smaller banks

Top 5 Next 95 Largest Smaller Banks

• Concentration intensifies the impact of mistakes

The Banking Bust 2008-2009

Total $$ of 165 failed Institutions: $542 BILLON TOTAL ASSETS OF (essentially 2) ASSISTED BANKS: $3.22 TRILLION (failure with a different label) BANK ASSETS DIRECTLY SUPPORTED ‘08-’09: $3.8 TRILLION + COMMERCIAL BANK ASSETS OF 7

OTHER FIRMS FORCED TO TAKE TARP FUNDS:

$4.0 TRILLION TOTAL BANKING ASSETS SUPPORTED:

$7.8 TRILLION

~2/3 of the commercial banking industry!

Dodd-Frank Act (“DFA”)

• Entrenches, rather than ends, Too-Big-

To-Fail

• Unworkable and unenforceable due to

length, scope, conflicts, and complexity

• 849 pages of statutes
• Over 14,000 pages of proposed regulations, so far
• Regulations roughly half completed
• Increased government intrusion and

weaker market incentives

Dodd-Frank Act (“DFA”) cont.

• Next financial crisis will be bigger and be

upon us sooner with DFA

• Last crisis cost $15-30 Trillion (1-2 years of output)
• DFA reinforces perverse incentives
• As a nation, we cannot afford to repeat these same

avoidable mistakes

• DFA reinforces perception of future

bailouts

• Designates large, complex financial companies as

“Systemically Important Financial Institutions” (SIFIs)

• Provides taxpayer funds for Debtor-In-Possession

financing of bankrupt holding companies and subsidiaries

• Perpetuates quasi-nationalization of largest financial

institutions as happened in 2008-09

The Dallas Fed Plan

1. Restrict the safety net (Deposit insurance and Fed lending) only for commercial banking and payments system activities 2. Counterparties acknowledge in writing that no government guarantees support their transactions with nonbank affiliates 3. Government encourages managements of largest banking institutions to streamline and downsize their companies so that any banking affiliate is certified by FDIC as “Too Small to Save” 4. Strengthen Section 23A of FR Act to severely limit asset transfers and sales from nonbank subs to banks subs.

BOTTOM LINE: Puts the “market” back in market discipline; recognizes the limits of regulatory discipline

Strengthen Dallas Fed Plan by

• Subsidy Reserve Plan – distribute accumulated

subsidy to shareholders only as significant asset sales occur (Professor Cornelius Hurley – Boston Univ.)

• Brown-Vitter TBTF Act requires 15 percent

capital-to-asset ratio for largest banking institutions

• Interesting recommendation by Luigi Zingales

(U. of Chicago)

• Big reduction in CDS price would trigger requirement

to issue equity within 30 days (like a margin call)

• Otherwise, BHC taken over by regulator and liquidated
• Will this work? Breakup at worst time? CDS

manipulation?

Summing Up

• Thanks in significant part to “Too-Big-to-Fail,”

the U.S. is “broke”

• Our enemies recognize this and treat us like the

toothless tiger we have become

• As a nation we simply cannot afford another

avoidable financial crisis

• Most of our political leaders talk about ending

“Too-Big-to-Fail,” but support policies that subsidize and perpetuate TBTF

• The Dallas Fed Plan, reinforced by Subsidy

Reserve Plan and Brown-Vitter, would bring an end to this hypocrisy.

In Conclusion

• THERE ARE SOME THINGS

MONETARY POLICY CAN’T FIX

Atkinson, Tyler, David Luttrell, and Harvey Rosenblum, “How Bad Was It? The Costs and Consequences of the 2007-09 Financial Crisis,” Federal Reserve Bank of Dallas, Staff Papers, July 2013. Bank for International Settlements, BIS Annual Report 2011/12, June 24, 2012, p. 75-6. Brown, Sherrod and David Vitter, Terminating Bailouts for Taxpayer Fairness Act (TBTF Act),

• S. 798, 2013.

Fisher, Richard and Harvey Rosenblum (2013a), “Vanquishing Too Big to Fail,” Federal Reserve Bank of Dallas, 2012 Annual Report. Fisher, Richard and Harvey Rosenblum (2013b), “Why we must downsize banking behemoths into ‘too small to save’ entities,” Dallas Morning News, Sept. 12, 2013. Fisher, Richard and Harvey Rosenblum (2013c), “A Credible Path for Ending Too Big to Fail,” Business Economics, Vol. 48, No. 3, p. 167-73. GAO, “Government Support for Bank Holding Companies: Statutory Changes to Limit Future Support Are Not Yet Fully Implemented,” GAO-14-18, November 2013. Hurley, Cornelius, “End ‘Too Big to Fail’ by Making It Shareholders’ Problem,” American Banker, January 23, 2013. Luttrell, David, Tyler Atkinson and Harvey Rosenblum, “Assessing the Costs and Consequences of the 2007-09 Financial Crisis and Its Aftermath,” Federal Reserve Bank of Dallas, Economic Letter, Vol. 8, No. 7, September 2013. Roe, Mark J., “Structural Corporate Degradation Due to Too-Big-to-Fail Finance,” University

• f Pennsylvania Law Review, forthcoming, (Draft dated November 7, 2013).

References

THANK YOU