Too Many Banks ‘Too Big to Fail’

The New York Times
ROB COX
Published: October 19, 2008
The financial crisis is forcing regulators to encourage the creation of bigger, more interconnected institutions. In the short term, this may serve a useful purpose by allowing healthier, well-capitalized banks like Wells Fargo, Bank of America and JPMorgan Chase to shore up weaker ones.
But it also presents a serious threat to the financial system by fostering financial behemoths that are, to use Federal Reserve Chairman Ben S. Bernanke’s euphemism, “systemically critical.” Policy makers need to start thinking about how to downsize institutions that are becoming “too big to fail” before the situation comes to that.
The basic problem is, in the argot of Wall Street, excessive concentration of risk — or, in layman’s terms, the placing of too many eggs in too few baskets. For the moment, it’s easy to see why regulators have encouraged acquisitions like JPMorgan’s of Washington Mutual and Bear Stearns, and Bank of America’s of Countrywide. These are a common tactic used in times of distress to spread capital across the banking system to fill in the weak spots.
Yet it’s creating some real monsters. Each of these three banks may be close to bursting through the regulators’ 10 percent cap on any one bank’s share of total United States deposits. Watchdogs might well show temporary forbearance, and later force banks to sell off deposits. Of course, none of the three are in a precarious position, but the failure of one would almost certainly wipe out the Federal Deposit Insurance Corporation’s reserves, which were stretched thin after the failure of IndyMac this year.
Because they have tendrils in many other, riskier businesses — among them investment banking, private equity and servicing hedge funds through prime brokerages — these mega-institutions pose risks to the financial system that could be beyond regulators’ ability to contain.
Indeed, Lehman Brothers’ failure showed that even smaller firms can be so interlinked through capital markets — particularly their more opaque corners like credit-default swaps — as to approach systemically critical status.
The worry is that because governments deem the biggest banks too important to fail, they could develop risk-taking cultures unchecked by the full discipline of a free market. This is something akin to what happened at Fannie Mae and Freddie Mac — and it could conceivably happen again.
It’s also one reason some investors have called for Citigroup, a sprawling global financial conglomerate that was until recently the largest American bank by assets, to be broken up.
Even if regulators are preoccupied with sorting out the current mess, they shouldn’t forget to address big concentrations of risk once the financial system looks more stable.
As Mr. Bernanke stated recently, the broad outlines of reform would include more robust regulation to make sure banks do not take advantage of their too-big-to-fail status. The financial infrastructure also needs strengthening. A clearinghouse for credit-default swaps, for example, would make that market less complex and more transparent. Finally, Mr. Bernanke wants a clear mechanism to handle the failure of nonbank financial institutions like Lehman. The Federal Deposit Insurance Corporation Improvement Act provides a blueprint for handling the collapse of banks. But the bankruptcy process is not suited to an orderly winding down of a securities firm with global operations.
All of Mr. Bernanke’s ideas make sense. But the most effective way to minimize the chance that institutions are too big to fail would be, well, to make them less big — and more to the point, less interconnected.
Regulatory carrots and sticks would help. One approach would be to further increase the cost of deposit insurance for banks that engage in practices deemed risky. Another would be to raise capital requirements in such a way as to force riskier businesses — possibly even entire divisions like fixed income, currencies and commodities trading — into separate, ring-fenced subsidiaries that are highly capitalized, or perhaps even make it practical for the banks to hive them off altogether as hedge funds.
These, too, could fail. But with damage confined to a smaller entity with less aggressive borrowing and no recourse to investors’ deposits, the financial system would have less difficulty absorbing the shock.