Too big to fail in two dimensions
By Mike Konczal
I want to lay out why I think size caps are an important supplement to the resolution authority as it is currently written in the Dodd bill in two posts. The first will be thinking about "too big to fail" in two dimensions, as if on a graph.
There is one popular argument that says that there is a myth of too big. This argument goes that the problem isn't that banks are too big, it is that we have these shadow banks, bank-like financial firms that are subject to liquidity runs. (See here if you are unfamiliar with the idea of a shadow bank run.) Even the smallest firms could be subject to a shadow bank run, and the largest firms could hold entirely cash and not be a worry at all. It's this liquidity risk that should worry us.
I want to plot out our ability to resolve a firm on two axes. The first is size of assets, the second is how risky the firm is in terms of a liquidity run. Let's plot Wells Fargo and Lehman Brothers, and then draw a green circle around them assuming that the Dodd Bill can resolve them both now.
During the crisis we lent TARP money to Wells Fargo, a large $1.2 trillion bank that is not primarily a shadow bank. We also failed to resolve Lehman Brothers, a $600 billion shadow bank. Though Lehman had excellent capital ratios when it failed, half of its liabilities were very short-term, on the order of one week, and thus were subject to a crisis of confidence in the repo market, a bank run.
Now let's plot these two in terms of the largest bank players: Here's why I don't think of "too big" as a myth for resolving a firm. In my mind, the farther you are from the origin in that graph, the harder it is for the government to detect problems and properly deter large firms under resolution authority. (This is why I draw our "safe" resolution as a circle, instead of a square.) Holding for a liquidity risk, the larger the firm, the more vicious the effects of having a shadow banking run on the rest of the financial sector and on the real economy. It is possible that the green circle here will be cast out far, and that size and pressures of campaign donations won't play a major part. But why take the chance?
-- Mike Konczal is a fellow with the Roosevelt Institute and the author of the Rortybomb blog.
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