• Too Big to Fail Got Even Bigger

    We just reached the 5 year anniversary of the end of Lehman Brothers and the financial collapse of 2008. The real question now is, are we safer now than we were then?

    After 2008, a group of financial institutions in the U.S. were deemed “too big to fail”. What that basically means was that there are intuitions so huge and intertwined, that if they went out of business, the impact on the entire economy would be devastating. Although we thought that we had learned this lesson the hard way in the Great Depression, and in 1933 enacted legislation called the Glass Steagall Act to prevent any institution from posing such huge risk to the economy again, the provisions under that act were repealed in 1999.

    So, to answer the question 5 years later, “too big to fail” banks are now 30% bigger than they were in 2008. Many experts also believe that the list too big to fail banks is getting even longer. The newest additions to the list may be AIG, Prudential and GE Capital.

    Looking back on the last 5 years, we can clearly see that we helped the big banks and hurt the small community banks – exactly the opposite of what we needed to achieve. The first reason is that once an institution has been designated a systemically important financial institution (SIFIs) by the new Financial Stability Oversight Council, it actually creates reverse incentives by providing a risk –free environment for credit lenders to that institution. It’s like saying the government will bail this institution out, no matter what, so creditors feel that they have no to low risk when they lend to these intuitions. Second, regulation that was enacted after 2008 to control risk in the SIFIs, is required of all financial institutions. So the smaller banks, who did not present the risk, are being punished and many have been put out of business, because the cost of compliance is so great. So instead of creditors requiring that the SIFIs take less risk, and moving to a model with more smaller institutions that do not present any systemic risk, we have achieved the exact opposite result. The big banks are bigger and more risky while the taxpayer is basically cosigning on their risk, and the smaller community banks are being punished with excessive regulation for risk that they never took.

    Another interesting aspect of all this is that criminal charges for the heads of the SIFIs have never been brought, because if those banks collapse, “we would undo all of the hard work that was done to save the bank in the first place”. A clever Rogue Media cartoon points out, “What’s better than too big to fail? Too big to jail.”

    too big to fail 2

    And in case you think that this is all in the past…the Wall Street Journal just reported that “J.P. Morgan Chase & Co. has offered to pay a record $13 billion as it seeks to settle criminal and civil investigations by federal and state prosecutors”. This case shows that not only have the regulators completely failed to reduce the risk, but that some institutions are not regulating what’s going on in their own banks.

    One piece of legislation that holds out some hope is the Warren-McCain-Cantwell-King bill, a “21st Century Glass Steagall Act” that reenacts sections 20 and 32 of the act which were repealed by the Gramm-Leach-Bliley Act of 1999. The most important piece of this financial reform is separation of investment banks and commercial banks. In a U.S. News article from July, Jim Lardner writes, “By removing some of the artificial advantages of enormous size in finance, Warren-McCain-Cantwell-King would create new running room for institutions, including many community banks and credit unions, that have stuck to the old-fashioned model of taking in deposits and giving out loans – only to lose more and more business to the six megabanks, which now hold double the assets of numbers seven through 50 combined.”

    So, in case you are wondering why you should care about any of this… experts agree that unless the risk that “too big to fail” institutions present to our economy is actually reduced, another financial crisis is inevitable, and that we will have no choice but to bail them out again. Unfortunately, the next crisis could be much worse because we will not have the political will or public backing to do it again. Every day, we see that Washington is completely incapable of working together; they are certainly not capable of taking action quickly enough to save our economy.

    Patrick Flynn

    Related Posts

Leave a reply.