THE FINANCIAL TIMES: At last – how America can solve the ‘too big to fail’ problem

Subsidy needs to be quantified, say William Isaac and Cornelius Hurley

January 17, 2013 6:46 pm
By William Isaac and Cornelius Hurley

Senators from opposite ends of the US political spectrum are finally asking the question that should have been answered before Dodd-Frank became law: how big is “too big to fail”?
Democrat Sherrod Brown and Republican David Vitter have asked the General Accountability Office, the investigative agency of the US Congress, to quantify the subsidy too big to fail banks receive from what are in effect taxpayer guarantees.

The subsidy is the funding advantage that the banks receive because their creditors know they will be made whole in the event of financial stress, just as creditors were during the financial crisis.
The drafters of the Dodd-Frank Act rarely stopped to consider the subsidy. Rather, they tried to prevent the next systemic failure with a fusillade of regulatory weaponry: elevated capital and liquidity standards, living wills, new resolution regimes and highly intrusive regulation. This approach ignores how market discipline is the essential tool in controlling risk-taking. The failure of a business must always be a realistic option.

Based on a growing body of academic literature, we believe the GAO will affirm that the too big to fail subsidy is larger than imagined. Armed with those results, the new 113th US Congress will be in a position to address the unfinished work of Dodd-Frank: systemic risk.

There are four ways to return the banks to a state where they are manageable, competitive and, ideally, no longer too big to fail.

First, they could be broken up. This approach appeals to base instincts. However, when one contemplates how the US would go about this and how disruptive it would be to the financial system and the economy, the solution looks daunting. Add some political horse-trading, and it is downright scary.

Second, the growth of the banks could be capped. This seems to be the US Federal Reserve’s preferred approach, at least according to a recent speech by Fed board member Daniel Tarullo. Caps have visceral appeal but they are arbitrary and perpetuate the problem. Besides, do we really want our largest financial institutions, controlling more than 50 per cent of the financial system, operating in a no-growth mode?

Third, the banks could be required to issue, at least annually, unsecured long-term senior and subordinated debt. Regulators could be prohibited from protecting these creditors in the event of a bank’s insolvency. If these banks’ total equity and long-term debt is set at 20 per cent of assets, it is highly unlikely that taxpayers would incur losses upon failure. Moreover, the discipline imposed by long-term creditors will curb risk-taking and make failure much less likely.

The fourth is a proposal we call the Subsidy Reserve Plan, which relies on market discipline rather than government intervention.

It would require each bank to establish a “subsidy reserve” line item on its balance sheet and add to it each year the estimated subsidy it receives from taxpayers in the form of reduced funding costs. The estimate would come from the GAO or the new Office for Financial Research. The reserve would not be considered part of the bank’s capital for regulatory purposes but would be available to protect creditors and the Federal Deposit Insurance Corporation in the event of failure.

The reserve would accrue year after year and could be distributed to shareholders only in proportion to a bank’s shrinkage via asset sales, divestitures or spin-offs. It could not be used for dividends, share buybacks or bonuses. If the bank shrank to a size such that it was no longer perceived as too big to fail, the subsidy reserve would end.

Over time, the reserve would accumulate such that it would be shareholders – not regulators or politicians – that would demand the shrinking of the bank. This is market discipline in its purest form.
We want financial companies to grow just as we want the economy to grow. But when they are so large or complex that the country cannot allow them to fail, the US needs to chart a different course. While awaiting the GAO’s findings, surely the US should be planning to resolve the too big to fail problem that still plagues its financial system.

The writers are, respectively, chairman of Fifth Third Bancorp and a former chairman of the FDIC; and director of the Boston University Center for Finance, Law & Policy.