Battling with the too-big-to-fail banks

Risky or reformed? Why the public still may not know the truth about large banks

Author: Mark Roe
May 7, 2015


Headlines about banks’ risks to the financial system continue to dominate the financial news. Bank of America performed poorly on the US Federal Reserve’s financial stress tests, and regulators criticised Goldman Sachs’ and JPMorgan Chase’s financing plans, leading both to lower their planned dividends and share buybacks. What was also of interest was Citibank’s hefty build up of its financial trading business that raises doubts about whether it is controlling risk properly.

These results suggest that some of the biggest banks remain at risk. And yet bankers are insisting that the post-crisis task of strengthening regulation and building a safer financial system has nearly been completed, with some citing recent studies of bank safety to support this argument. So which is it: are banks still at risk? Or has post-crisis regulatory reform done its job?

Bankers are insisting that the post-crisis task of strengthening regulation and building a safer financial system has nearly been completed

The 2008 financial crisis highlighted two dangerous features of today’s financial system. First, governments will bail out the largest banks rather than let them collapse and damage the economy. Second, and worse, being too big to fail helps large banks grow even larger, as creditors and trading partners prefer to work with banks that have an implicit government guarantee.

Balancing the figures
Too-big-to-fail banks enjoy lower interest rates on debt than their mid-size counterparts, because lenders know that the bonds or trading contracts that such banks issue will be paid, even if the bank itself fails. Before, during, and just after the 2007-2008 financial crisis, this provided an advantage equivalent to more than one third of the largest US banks’ equity value.

Bailouts of too-big-to-fail banks are unpopular among economists, policy makers, and taxpayers, who resent special deals for financial bigwigs. Public anger gave regulators in the US and elsewhere widespread support after the financial crisis to set higher capital and other safety requirements.

And more regulatory changes are in the works. New studies, including important ones from the IMF and the US Government Accountability Office, do indeed show that the long-term boost afforded to too-big-to-fail banks like Citigroup, JPMorgan Chase, and Bank of America is declining from its pre-crisis high. This is good news.

The bad news is that US bank representatives cite these studies when claiming, in the financial media and presumably to their favourite members of Congress, that the too-big-to-fail phenomenon has been contained and that the time has come for regulators to back off.

This is a dangerous idea, for several reasons. For starters, the IMF’s research and similar studies show that the likelihood of a bailout over the life of the bonds already issued by banks is indeed now lower. But the studies do not specify why. Lower bailout risk could reflect the perception that the regulation already in place is appropriate and complete. Or bond-market participants may expect that new regulations, like the stress tests, will finish the job. The studies could be telling us that investors believe that regulators are on the case and have enough political support to implement further safeguards. Or they could think that the economy is currently strong enough that the banks will not fail before the bonds are paid off in a few years.

The bigger picture
The second reason why such studies should not deter regulators from continued intelligent action is that the research focuses on long-term debt. But that is not the right place to look nowadays, because regulators are positioning long-term debt to take the hit in a meltdown, while making banks’ extremely profitable – and far more volatile – short-term debt and trading operations more certain to be paid in full.

As a result, traders choose too-big-to-fail banks, rather than mid-size institutions, as counter-parties for their short-term trades, causing the large banks’ trading books – and, hence, their profits – to surge. Measuring the boost to short-term debt is not easy. But it is most likely quite large.

The major banks’ recent effort, led by Citigroup, to convince the US Congress to repeal a key provision of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act that would have pushed much of their short-term trading to distant affiliates (which are not too big to fail) reinforces this interpretation. The banks know that they will receive more business if they run their trading desks from the part of their corporate group that has the strongest government backing.

The third reason to be wary of bankers’ confidence that the regulatory job is complete is that once they believe it, they will behave accordingly – less frightened of failure and thus willing to take on more risk. That seems to have been the case before the financial crisis, and there is no business or psychological reason to think that it will not happen again.

Regulators must not be deterred by bank lobbying or studies that measure neither the short-term boost afforded by a bank’s too-big-to-fail status, nor how much of the perception of increased safety can be attributed to the regulations in place and the expectation of additional good regulation. In the absence of such studies, regulators must use their own judgment and intelligence. If ‘too big to fail’ also means ‘too big to regulate’, the perception of increased safety will not last long.

Mark Roe is a professor at Harvard Law School. He has written a series of articles on banking reforms for Project Syndicate, the FT and The Wall Street Journal.

© Project Syndicate, 2015