How to End 'Too Big to Fail'



  • A tiny percentage of banks hold most industry assets.
  • The TBTF global subsidy has been estimated as being worth $300 billion (annually) for the largest 29 banks. 
  • There should be more than the present two solutions: bailout or the end-of-the-economic-world-as-we-have-known-it. Both choices are unacceptable.

Dallas Federal Reserve President Richard Fisher gave a great speech last week about ending “too big to fail” (TBTF) — the situation where a handful of banks are so large and important to the economic system that it is implicitly understood that the government would bail them out, rather than let them fail. Here are a few highlights (most of this is lifted straight from the speech or is slightly paraphrased):

1. TBTF defined. Fisher defined TBTF as firms whose owners, managers, and customers believe themselves to be exempt from the processes of bankruptcy and creative destruction.

2. Moral hazard. These firms are effectively subsidized (compared with their non-TBTF competitors), and the result is that they are likely to take greater risk in search of profits.

3. Hurting the recovery. These banks are limiting the effectiveness of monetary policy because sick banks don’t lend.

4. Ineffective regulatory solutions. Now, Dodd-Frank has 16 titles and runs 848 pages. More than 8,800 pages of regulations have been proposed (and we’re not done).

5. Dallas Fed’s solution to TBTF. The Dallas Fed believes that only commercial banking operations (not shadow banking facilities or the parent company) should benefit from the safety net of federal deposit insurance and access to the Fed’s discount window.

6. There are a few HUGE players. Approximately 98.6 percent (5,500 out of 5,600) of U.S. banking organizations are community banks with assets less than $10 billion. They account for only 12 percent of total industry assets. There are 70 banks with assets between $10 billion and $250 billion. They account for 1.2 percent of banks and 19 percent of assets. Finally, there are 12 institutions with assets between $250 billion and $2.3 trillion. These are .2 percent of all banks, but they hold 69 percent of industry assets. 

7. Little outside control over the TBTF banks. In comparing the different-size banks, Fisher doesn’t believe that there’s much regulatory authority or investor control over the large banks. Because management does not believe that they would be allowed to fail, regulators have little control over the largest banks. Unsecured depositors and creditors offer their funds at a lower cost to TBTF banks than to mid-sized and regional banks that face the risk of failure. 

8. Huge financial subsidy. The TBTF global subsidy has been estimated as being worth $300 billion (annually) for the largest 29 banks. To put this in perspective, all the U.S. bank holding companies summed together reported earnings of $108 billion in 2011.

9. Tremendously complex. See this chart to understand just how complex the five largest U.S. banks are.

10. More of the solution. We must reshape TBTF banking institutions into smaller, less-complex institutions that are economically valuable; profitable; competitively able to attract financial capital and talent; and of a size, complexity, and scope that allows both regulatory and market discipline to restrain excessive risk taking.

11. Let's not penalize the majority of banks. At present, 99.8 percent of the banking organizations in the U.S. are subject to sufficient regulatory or shareholder/market discipline to contain the risk of misbehavior that could threaten the stability of the financial system. Only .2 percent are not. Furthermore, to contain that risk, regulators and many small banks are tied up in regulatory and legal knots at an enormous direct cost to them and a large indirect cost to the economy.

12. We need an alternative solution. There should be more than the present two solutions: bailout or the end-of-the-economic-world-as-we-have-known-it. Both choices are unacceptable.

I love the fact that Fisher is keeping the pressure up on this issue. Remember that Fisher was the member of the FOMC who was saying that there were significant problems that were going to play out with our banks as the crisis started.  While I tend to favor the required use of contingent convertible debt by banks, I’m just happy that we’re still talking about it.



The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance, McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

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