Regulators recently rejected plans from five too-big-to-fail banks, saying they haven't found a way to go bankrupt without relying on taxpayers to bail them out. If they can't fix it, they're supposed to be broken up.
So why are we suddenly debating the very concept of "too big to fail" instead?
If that debate sometimes seem complicated – well, maybe some people want it that way. But the problems these regulators identified are plain enough.
‘Til Death Do Us Part
Five big banks – JPMorgan Chase, Bank of America, Bank of New York Mellon, Wells Fargo, and State Street – received failing grades from U.S. regulators in the design of their “living wills.” Those are the banks’ plans to dissolve themselves in an orderly fashion if they begin to collapse into bankruptcy.
Two regulators, the Federal Reserve and the Federal Deposit Insurance Corporation, issued their “living will” determinations jointly for the first time. One of the two agencies also gave a failing grade to Morgan Stanley. The other failed Goldman Sachs. Citigroup passed with “shortcomings.”
The FDIC chair issued a celebratory statement about the findings. But vice chair Thomas Hoenig, who had a ringside seat at the 2008 crisis as a senior Fed official, said that the plans showed that none of the too-big-to-fail banks were “capable of being resolved in an orderly fashion through bankruptcy." He added:
"The goal to end 'too big to fail' and protect the American taxpayer by ending bailouts remains just that: only a goal.”
Suddenly, A Controversy
Why aren't people talking about this? Instead there are those who would rather relitigate the whole question of "too big to fail." Why?
Here's one reason: Sen. Bernie Sanders (disclosure: I work for Sanders' Democratic presidential campaign) has called for breaking up the big banks, and supporters of candidate Hillary Clinton are pushing back. There are undoubtedly others.
Paul Krugman argues that “shadow banks” like the insurer AIG and Lehman Brothers, along with other “non-Wall Street institutions,” are the real problem, and that they are outside the scope of a “too big to fail” solution. (Clinton herself has taken the same position.)
Barney Frank attempts to turn the judicious remarks of too-big-to-fail critics into some sort of admission of failure, arguing that their willingness to evaluate each case rather than arbitrarily set a maximum bank size is somehow an admission that “the central question of how big is’ ‘too big’ is too hard to answer.”
Andrew Ross Sorkin of The New York Times even says that “generalists,” including judges, are incapable of determining whether an institution is too big to fail or not.
Too Complicated to Understand?
Is it, as Barney Frank insists, "too hard" to know when an institution is "too big"? Apparently not. A new group set up by the G-20 nations doesn’t seem to have any trouble recognizing too-big-to-fail banks. It termed them as “global systemically important banks,” or GSIBs, and has publicly listed 30 of them.
Sorkin based his "generalists just don't understand" argument on the MetLife case, in which the financial conglomerate successfully persuaded a federal judge to overturn its too-big-to-fail designation. Who but a highly trained specialist can know if Snoopy has become a global threat?
But economist, lawyer, and former bank regulator William K. Black notes that MetLife reported assets of $878 billion at the end of last year. As Black points out, “it has over $200 billion more in reported assets that Lehman claimed when it failed – and Lehman triggered a global crisis.”
It does not require specialized knowledge – or any of the magical calculations Sorkin describes (and Black ruthlessly dismantles) – to understand that MetLife could pose a systemic threat to the economy.
Then there's JPMorgan Chase. Pam Martens and Russ Martens point out that it has a vast derivatives portfolio, with a notional value of $51 trillion, and 63 percent of its derivatives do not pass through the clearing houses established by Dodd-Frank. Instead they are handled in over-the-counter transactions with unknown counterparties.
The risk in both cases is clear – and other too-big-to-fail institutions have equally troubling profiles.
Standing In the Shadows Of Wall Street
What about shadow banks? Where do they fit in?
One of the key things to remember about financial institutions today is that they are deeply interconnected. Any one of them, whether it's designated as a "bank" or is one of the more nontraditional corporations in the financial sector, will have interlocking financial relationships with a broad webwork of other players. Large "shadow banks” are financially entangled with too-big-to-fail banks. That’s why the failure of Lehman Brothers nearly brought down the global economy, and why it was necessary to spend $185 billion rescuing AIG.
Actually, a better term for the “AIG rescue” might be “the rescue of AIG and its counterparties” – that is, the banks that stood to lose billions if it went under. The list of counterparties cited by Pam Martens and Russ Martens includes Goldman Sachs, which received nearly $13 billion in rescue funds through AIG. Other U.S. banks that received billion-dollar payouts from the taxpayer, via AIG, include Citigroup and Merrill Lynch (along with its parent, Bank of America.)
The old distinctions mean less than they once did. Many shadow banks are clearly too big to fail. Their failure in 2008 would have certainly have caused irreparable harm to too-big-to-fail banks. What's more, at least two non-banks (Goldman Sachs and GE Capital) were retroactively given bank status so that they could receive bailouts.
It's a straw-man argument to say that "too big to fail" solutions ignore shadow banks. They, and the institutions that have already been designated "banks," are all parts of the same problem. No financial institution, whatever its labeling, should be allowed to pose a threat to the economy. All of them should be properly regulated.
Banks Merely Innocent Bystanders?
Without naming Krugman, Sen. Elizabeth Warren called arguments like his “revisionist history,” adding that “Wall Street lobbyists have tried to deflect blame for years, but … there would have been no crisis without these giant banks."
As Ben Walsh and Zach Carter wrote in their Krugman response, it would be foolish to ignore the role shadow banks played in the crisis, but “attempting to write big banks out of the history of the financial crisis … reduces (that) history … to campaign talking points.”
They add that it's "weird" to be forced to argue the culpability of big banks in the financial crisis once again, in 2016. But, they add, "that’s what the Financial Crisis Inquiry Commission found. Federal Reserve Chairman Ben Bernanke, former IMF chief economist Simon Johnson, former Federal Deposit Insurance Corp. Chair Sheila Bair, former bank bailout Inspector General Neil Barofsky, FDIC Vice Chairman Thomas Hoenig, and Sen. Elizabeth Warren (D-Mass.) have all concluded that ‘too big to fail’ was, in fact, central to the crisis.”
How are the big banks behaving now? Have they mended their errant ways?
The Office of the Comptroller of the Currency (OCC), which is responsible for national banks, reported at the end of 2015 that a trend toward increasingly lax underwriting standards “reflects broad trends similar to those experienced from 2005 through 2007, before the most recent financial crisis….” That seems like the behavior of people who don't think they'll ever have to face the consequences of their own behavior.
Those who do not study history – or who choose to ignore it – are doomed to repeat it. So why are we even arguing about this?
Democrats Aren’t Always Tough on Banks
Some Democrats aren’t as tough on Wall Street as they like to act. Not one senior banking executive was indicted by President Obama's Justice Department, even though banks have paid out some $200 billion to settle fraud charges. Those frauds didn’t commit themselves – but nobody’s gone to jail, or even paid back their ill-gotten bonuses.
An example: Recently released documents show that the that the Financial Crisis Inquiry Commission referred Robert Rubin – who went from serving as Bill Clinton’s Treasury secretary to running Citigroup – to the Department of Justice because it believed Rubin “may have violated the laws of the United States in relation to the financial crisis.” There is no evidence that any investigation ever took place. The lack of action, in this and so many other cases, is ... well, it's not very tough.
And the beat goes on. A recently announced $5 billion settlement between the government and Goldman Sachs amounted to significantly less than meets the eye. It included no civil or criminal penalties for the bankers who conducted the multibillion-dollar fraud or the executives who managed them. Phil Angelides, former chair of the Financial Crisis Inquiry Commission, wrote that the settlement “will not deter future financial lawbreaking and will further undermine the public’s faith in the fairness of our legal system.”
Hillary Clinton certainly sounded tough in the latest Democratic presidential debate, when she was asked if she would break up the big banks. “I will appoint regulators who are tough enough and ready enough to break up any bank that fails the tests under Dodd-Frank,” citing living wills as one such test.
So would Hillary Clinton really break up JPMorgan Chase, Bank of America, Wells Fargo, State Street and Goldman Sachs if they continue to fail the living will test? Nobody seems to think so – which may explain the vehemence of the side arguments presented by Messrs. Frank and Krugman.
Dodd-Frank Didn’t Fix Everything
They want us to believe that Dodd-Frank fixed Wall Street. It was clearly an improvement over the status quo. But it left too much to the discretion of those “tough regulators,” many of whom – like their colleagues in the Justice Department – had long-standing relationships with the industry they were expected to regulate.
Dodd-Frank didn’t restore the protections of Glass-Steagall that would separate standard consumer banking from Wall Street speculation – protections that are sorely needed – and it didn’t fix “too big to fail.”
It’s not as if nobody knew its shortcomings at the time. When Dodd-Frank passed, the New York Times said it would "change Wall Street around the edges” but would "not threaten the finance industry's basic business model." Matt Taibbi wrote that “taken together, these reforms fail to address even a tenth of the real problem.”
Simon Johnson expressed concern that it didn’t provide enough authority to wind down larger institutions with international holdings, and added that “it has never been clear that any government agency would be willing to use such resolution powers pre-emptively – before losses grow so large that they threaten to rock the macroeconomy.”
Now Johnson says the banks are still too big to fail and that "as long as that remains the case, another disaster is only a matter of time."
What’s the Answer?
The simple fact remains: Even if our too-big-to-fail institutions each gave us a credible-sounding “living will,” we could never be sure it would actually be implemented successfully during a real crisis.
Would regulators move quickly enough to wind down dangerous institutions in an emergency? We wouldn’t know until it was too late. There’s only one way to protect the global economy from the dangers of too-big-to-fail banks:
Break them up.