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A primer on 'too big to fail'

David Min offers perhaps the clearest explanation of the "too big to fail" problem that you'll find anywhere:

“Too big to fail” is best understood as a bank panic problem, and has arisen as the result of two developments in the global financial markets over the past several decades. The first development was the tremendous growth of a “shadow banking system” operating outside of the rules that have governed depository banking since the Great Depression. This shadow banking system essentially performed the same functions as banking — attracting short-term investments and using them to finance long-term loans — but did so through the use of entities that were not depository banks, and the use of financing instruments (such as mortgage-backed securities, commercial paper, or short-term repurchase agreements) that were not deposits. Because of this nonbank, nondepository structure, the shadow banking system, which grew to an estimated $10 trillion in size, fell outside the rules and protections of the regulated banking system.

The second development was the concentration of risk within the shadow banking system, such that a small number of financial firms were and are responsible for the vast majority of its liabilities. Before the 2008 crash, the five major U.S. investment banks had a combined balance sheet size of approximately $4 trillion, and this may have understated the true level of liabilities they were holding. Witness the recent revelations about failed Wall Street investment bank Lehman Brothers, which raises questions about the extent to which shadow banks offloaded balance sheet risk through the use of dodgy transactions.

I'm a bit concerned that a lot of the public energy on financial regulation is attaching itself to the Consumer Financial Protection Agency because that's both more comprehensible and more politically useful for Democrats. But how you deal with the TBTF problem is much more important.

By Ezra Klein  |  March 24, 2010; 3:16 PM ET
Categories:  Financial Regulation  
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The TBTF problem isn't going to go away, because, for those prominent folks at the treasury and in financial regulation, TBTF is a code-phrase for "my friends got greedy and effed up, so I've got cover them and make them whole, so they don't have to give up their second and seventh vacation homes, their yachts, or those million dollar parties they invite us to. And by 'I've got the make them whole', I mean the American Taxpayer."

The reason any entity is too big to fail has more to do with who gets invited to whose party, who is whose neighbor, and who donates to what politician or PAC, than the actual threat posed to the markets by their failure. As such, any solution that doesn't involve the taxpayers propping up the super-rich will never come to be.

Posted by: Kevin_Willis | March 24, 2010 3:52 PM | Report abuse

Higher top marginal tax rates, a small transaction tax, increased reserve requirements to reduce leverage, and regulate derivatives, preferably requiring them to be traded on a transparent market.

Posted by: Mimikatz | March 24, 2010 4:03 PM | Report abuse

I think the CFPA would be important to the little people who don't have the time or temperament to decipher all the fine print (and that is the majority of people). What they need is a standardized, "recommended" product (perhaps two) in each financial category, which they can sign-up for without being taken to the cleaners.

But I suspect the CFPA will be charged with approving all products, creating an almost useless morass of offerings. 'Choices' the free market types say. 'Nonsense' say the pragmatists.

But yes, TBTF is the bigger problem given the recent demonstration of its potential to damage the entire economy.
But let's consider first what solving TBTF might mean, and yes bank panic or financial institution panic and excessive risk (i.e. cow dung assets managed by donkeys) characterizes it.

First, TBTF to many means negating the moral hazard brake. Does anyone (I should say any serious, sensible one), really think these bozo's seriously contemplated that their institutions might fail? What was it that Chuck Prince said. Musical chairs anyone. Or smiley face Vikram Pandit profusely thanking all of us for the money, and in the next breath saying it was not necessary! Is the death penalty a deterrent? I.e. don't waste time worrying about moral hazard. Those who actually care about it, wouldn't do this stuff anyway.

But let's take the 10 or so US biggest US institutions plus 30 or so more around the world and break them up into 80 or 120 entities. That further spreads the risk, but doesn't reduce the overall level risk (junk assets in this case). Under this scenario 3 years ago, i fail to see how the housing bubble would have been any less severe or when it burst any less damaging to the economy. Maybe more so, since the Fed and Treasury (and their colleagues around the world) would have had that many more institutions to deal with.

The real issue to be dealt with is the types and magnitudes of toxic assets and transactions which caused the problem. They either need to be outlawed or most of their funding sources (tax advantaged public and private pension funds, 401-k's, etc.) dried-up. If rich people want to bet their money in this casino, be my guest. Just don't affect the rest of us.

And there-in lies a fairly direct connection between TBTF and the CFPA.

Posted by: joemken | March 24, 2010 4:40 PM | Report abuse

What Mimikatz said. I would add a very modest wealth tax to balance the wealth tax (with a generous retirement plan exemption) we have on real estate (the only source of equity that the vast majority have). This might make capital gains tax lower or eliminate it completely.

Posted by: srw3 | March 24, 2010 5:11 PM | Report abuse

When Dodd came out with his bill, I read the summation. Then I began reading analyses from various economists and financial writers. Many of them are listed on your sidebar. The more I read and digested, the more upset and angry I became. Dodd's bill is a waste of time and effort!

The CFPA will have no authority to effect change because the FSOC can over rule anything the CFPA wants to do.

The FSOC is made up of the usual regulators that messed up so badly this time - and what happens if another deregulation President appoints regulators who are opposed to regulation?

The $51B bank provided fund to finance resolution, if needed, wouldn't resolve your local bank, let alone a Citi or BofA. The fund would need to be around $400B, minimum.

The agencies are set up to "recommend" action not enforce it.

No wall is created between proprietary trading and customer advising.

Rating agencies, like Moody's, will still be paid by their customer banks to rate that bank's products. Can anyone say, Conflict of interest?

Not all CDSs and CDOs, etc., are required to be traded openly and transparently on exchanges and boards so customers can see their real value.

Essentially, this legislation does nothing but give the appearance of regulation without actually doing any regulation. It's a hoax!

And, yes, I'm angry. Bloody angry!!!!

Posted by: valkayec | March 24, 2010 8:03 PM | Report abuse

The worst TBTF problems are Fannie and Freddie Mac. The Government guaranteed their debt while pushing them into riskier enterprises, and it's going to cost us vast sums of wasted money.

Posted by: tomtildrum | March 24, 2010 8:13 PM | Report abuse

Oh, and regarding TBTF, I go along with Simon Johnson (Baseline Scenario). Set limits - "no financial institution should be allowed to control or have an ownership interest in assets worth more than 4 percent of U.S. gross domestic product, or roughly $570 billion in assets today. A lower limit should be imposed on investment banks -- effectively 2 percent of GDP, or roughly $285 billion."

That reduces the moral hazard as well as the systemic risk. But Geithner, et al, don't want to do that. Easier to pretend that Wall St will behave, I guess.

Posted by: valkayec | March 24, 2010 8:13 PM | Report abuse

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