An Alternative Plan to Fix TBTF: Lay Big Banks’ Subsidy Bare

in Announcements, In the News
July 24th, 2013

From American Banker
By Barbara A. Rehm
July 24, 2013

Ending “too big to fail” may be the single public policy goal that everyone in financial services agrees on.

Obama administration officials, federal regulators, lawmakers from both parties, even executives at the largest banks are united: the government shouldn’t ride to the rescue every time a giant financial firm falters.

But five years beyond the crisis few people are convinced the 2008 bailouts won’t be repeated.

Many, myself included, put a lot of faith in Dodd-Frank’s Orderly Liquidation Authority, which mandates insolvent behemoths should be taken over and unwound by the government.

But the Federal Deposit Insurance Corp. seems to have hit a wall in its OLA implementation, stuck waiting for the Federal Reserve Board to adopt a rule requiring long-term holding company debt that could be converted into equity in a resolution.

Fed officials are convinced that if they can only layer enough capital requirements onto the largest banks and gradually crank these ratios higher, the companies will conclude it’s in their best interest to shrink.

But will they? Bankers tell me their companies have zero interest getting below $700 billion, the new threshold for lower capital levels adopted this month. First, it would take forever to do this organically and, second, asset sales of that scale would never be approved by regulators for fear they would be making some other bank “too big.”

The largest banks also are convinced they will be able to live with whatever capital rules the government concocts. “We will find a way to earn a [market] return on our capital,” one banker told me.

All this leads me to think that trying to solve TBTF through capital is not as simple as we’d all like.

Besides, capital rules themselves are becoming a mess. We are well on our way to a dozen separate ratios or surcharges and several different ways to calculate a capital ratio’s denominator. No one can even explain how the “new” leverage ratio adopted this month relates to the old one. And honestly no one knows how much capital is “enough” or whether all these new rules will simply push risk out of the regulated financial system.

That’s enough to convince me we ought to at least consider other options.

Enter Boston University professor Con Hurley and his plan to require systemically important firms to set aside reserves equal to the net advantage — funding and otherwise — they get for being big.

Hurley has worked both for a bank (Shawmut Corp.) and a federal agency (the Fed) and now runs the nation’s oldest graduate program focused on financial law. He’s been working on this idea since 2008 and this summer his local congressman, Michael Capuano, a Democrat, introduced it as legislation.

The Subsidy Reserve Act of 2013 would require the Fed, working with the Financial Stability Oversight Council’s Office of Financial Research, to “establish a formula for determining the financial benefit” that big firms receive when “shareholders, creditors, and counterparties” believe that the government “will shield them from losses in the event of failure.”

In other words, the financial benefit of being big would have to be set aside as a reserve each year. These reserves would not count towards regulatory capital requirements and couldn’t be used to pay dividends or buy back shares or pay executives. The reserve would just sit on the bank’s books and accumulate over time.

“It’s earnings that the company didn’t earn. These earnings were given, in the form of free insurance, subsidy, whatever you want to call it,” Hurley said in an interview Tuesday. “It’s a subsidy from the taxpayers. If you clean the slates every Jan. 1 and let them use that subsidy to buy stock or dividend it out, then what’s the point? The idea of having it accumulate is that over time this gift from the taxpayers can be used to incent them to get smaller.”

Hurley views this cumulative feature as a market-based way to solve TBTF. As the reserve builds up, shareholders would apply pressure on these firms to get smaller. The only way for a giant to reduce its reserve would be to shrink through asset sales, divestitures or spinoffs.
“It will not take long for recalcitrant managers to be challenged by their shareholders demanding the release of this capital through the rightsizing of the institution,” Hurley explains. “Note that it is market discipline, not regulators or politicians, making this happen. All this can be accomplished simply by shifting our focus away from arbitrary capital levels and toward the taxpayer subsidy of the TBTFs.”

Hurley calls it a choice of “capital punishment versus capital cure.”

The issue has gained some traction on the other side of Capitol Hill as well.

The Senate’s leading TBTF warriors — Sherrod Brown of Ohio and David Vitter of Louisiana — have the Government Accountability Office studying the size of the subsidy. The GAO has been meeting with experts all summer and is expected to release some foundational findings in the fall and the meat of its report in early 2014.

The senators asked GAO to calculate the financial benefits banks with more than $500 billion of assets receive from the market’s perception that they are too big to fail. For instance, how do higher credit ratings lower debt costs or produce more favorable terms from counterparties or creditors? Can these banks offer lower rates on deposits than smaller companies?

“Right now the subsidy is like heat off a smokestack, it’s not accounted for. It’s just a subsidy that everyone knows is there,” Hurley says. “If you ignore it, you are ascribing a value of zero to it and that’s inaccurate.”

Plenty of people have studied the existence and size of the subsidy and most of the numbers they’ve come up with are big. Depending on the formula’s design, Hurley realizes that this reserve could be enormous and could force massive changes at the large banks. That’s not necessarily his goal.

“If the subsidy is too huge and too disruptive, then phase it in or don’t accrete 100% every year,” he says. “But I do think the kernel of the idea is where we have to go with this. If we are going to underpin the very existence of these firms, then there is a benefit to that. The longer we ignore that benefit, the more unfair, the more contorted the financial system is.”

A simple accounting of the subsidy would be better than nothing, he says.

Even if the Securities and Exchange Commission “just made ‘too big to fail’ banks have an accounting entry or an off-balance item identifying their subsidy, I think that would go a long way toward curing this, because the public awareness of it would dictate a solution.”

Advocates for the largest banks argue that any advantage comes not from an implicit government guarantee but from scale or scope or superior management.

Hurley agrees those factors play some role.

“That’s the challenge that GAO is facing and that the Fed will face: how do you separate the implicit guarantee from the benefits of being large and diversified,” he says. “I don’t pretend to deny a large institution the benefits of that. All I’m trying to do is separate the financial advantage that goes with the implicit guarantee versus those other good things. Obviously it’s to the advantage of the big banks to say, ‘Oh it’s all because we’re wonderful and have the perfect business model,’ but we know that isn’t so.”

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