In a recent New York Times Op-Ed article, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, wrote that despite financial reform legislation, the biggest banks still control our economy and pose a serious threat. After the last round of bailouts “the five largest financial institutions are 20 percent larger than they were before the crisis. They control $8.6 trillion in financial assets — the equivalent of nearly 60 percent of gross domestic product. Like it or not, these firms remain too big to fail.”
“Too big to fail” is a threat that should not be ignored. The financial system is the life blood of the economy. Firms need to borrow for investment purposes from banks, other financial institutions, and from the bond and stock markets. Consumers borrow from banks and credit unions to finance lumpy purchases such as automobiles, houses, appliances and the like. Thus the financial system is deeply intertwined with the entire economy. Iif a large bank or other financial institution goes bankrupt, it takes many other firms down with it, threatening the entire economy.
Thus, the political reality: Large financial institutions will not be allowed to go under whether there is Democratic or Republican control of government.
The very large size of the major banks and the fact that they are seen as “too big to fail” has an unfortunate incentive effect on bank executives if they know they will always be bailed out even if they are reckless in their risk taking. This gives rise to what in the insurance industry is called a “moral hazard.” When a person buys auto theft insurance, for example, they have less incentive to be careful, say, by locking the car doors. If their car gets stolen they will be compensated by the insurance company. Likewise, bank executives will be tempted to take on more risk than is prudent when they know they will be bailed out by government, as happened this past financial crisis.
If large banks and other financial institutions will not be allowed to go bankrupt, what can be done to reduce the incentives to take on too much risk? One possibility, of course, is to break up existing banks above some maximum size and enact regulations that will make it difficult for others to grow beyond that maximum. Then the much smaller banks can be allowed to fail when they overextend. However, this is an unlikely possibility. Neither political party has been serious about downsizing over-grown financial institutions.
If breaking-up the very large financial institutions is not on the table, what other policies might be possible to avert another implosion caused by the financial sector taking on excessive risk? One way to think about the “too big to fail” issue is that in effect the government is taking on an implicit liability for bailing out extra large firms which, in fact, is a subsidy to them. This encourages banks to get bigger so they can benefit from that implicit subsidy. Therefore, what is needed are policies that reduce the incentive for risk-taking and/or policies that make it difficult to grow ever larger.
A partial, piecemeal approach would, among other things, establish minimum capital requirements for all large financial institutions above a certain size. For example, Switzerland has mandated that their two largest banks, UBS and Credit Suisse, have 19 percent capital by 2019. This will give the banks a cushion of time during the next financial crisis when they can pay their debts and work out other arrangements to remain solvent. In addition, it can be required that in a crisis some bondholders will have to accept non-payment or have their bonds converted to stock.
Charles K. Wilber is a Notre Dame professor emeritus of economics and fellow of the Kroc Institute for International Peace Studies who has written widely on Catholic social thought and economic theory. His most recent books are Economics and Ethics: An Introduction (Palgrave Press, 2010) with Amitava Dutt and Catholics Spending and Acting Justly (Ave Maria Press, May 2011). Email him at firstname.lastname@example.org.