In one of his most definitive statements on the subject to date, the nation's central banker said Thursday that he expects some of the nation's megabanks to start getting smaller.
"The most important lesson of this crisis is we have to end Too Big To Fail," Federal Reserve Chairman Ben Bernanke testified before the Financial Crisis Inquiry Commission. "My projection is that, even without direct intervention by the government, that over time we're going to see some breakups and some reduction in size and complexity of some of these firms as they respond to the incentives created by market pressures, and regulatory pressures as well."
Throughout the legislative slog toward financial reform, Bernanke -- like the Obama administration -- resisted congressional efforts to break up the handful of too-big-to-fail firms that dominate the financial system. In May, however, a third of the Senate voted to effectively bust up the biggest of those giant financial institutions.
That effort didn't succeed, but Bernanke attempted to put some lingering concerns to rest during his critical questioning by the panel created to investigate the roots of the financial crisis.
The nation's four biggest lenders collectively hold about $7.5 trillion in assets, according to their most recent quarterly filings with the Fed. That's equal to more than half the estimated total U.S. output last year, International Monetary Fund figures show.
Those four banks -- Bank of America, JPMorgan Chase, Citigroup and Wells Fargo -- each hold more than $1 trillion in assets. BofA and JPMorgan each have more than $2 trillion. The four giants control about 48 percent of the total assets in the nation's banking system, according to Fed data collected through March 31.
In 2001, it took 16 banks to control half of the market, Fed data show.
During the height of the financial crisis, the same four firms received or benefited from hundreds of billions of dollars in taxpayer funds in direct equity investments and guarantees on debt and assets. Effectively deemed too big to fail, meaning that any one of their failures could have destabilized the financial system, the lenders were rescued from failure -- and have since prospered, thanks to widening spreads between how much banks pay for funds and how much they charge borrowers.
"Too-big-to-fail financial institutions were both a source (though by no means the only source) of the crisis and among the primary impediments to policymakers' efforts to contain it," Bernanke wrote in his prepared remarks.
Yet when presented with the opportunity, the Obama administration declined to break up the banks. Instead, administration officials argued that a combination of stricter regulation, higher capital requirements and a new hybrid regime that combines bankruptcy with the Federal Deposit Insurance Corporation's bank-failure process would send the message that these firms would indeed be allowed to fail, and that it would be too expensive for them to remain so large.
Noted economists, former bank regulators and some presidents of regional Fed banks have panned that reasoning.
The crisis commission seemed likewise skeptical Thursday, peppering Bernanke -- as well as FDIC Chair Sheila Bair, who was next to testify -- with questions regarding the new financial-regulatory law's ability to end Too Big To Fail.
Bernanke told them that the breakup of the big banks, which Democratic Sens. Ted Kaufman (Del.) and Sherrod Brown (Ohio) could not get the Obama administration to rally behind, will happen naturally. In effect, it will be too expensive to be Too Big To Fail, and so the firms will get smaller.
But that process won't be painless.
"Let me just be clear: this is not going to be easy to implement," Bernanke warned. "I think the one area that's going to take a lot of effort is the international element." As an example, he said, likely referencing Citigroup, "one of the banks that we supervise has offices in 109 countries, each one with its own bankruptcy code and its own rules and so on."
Prominent critics of the bill's perceived shortcomings in ending Too Big To Fail -- like Simon Johnson, a former chief economist of the International Monetary Fund and a contributing editor for the Huffington Post -- have pointed to the byzantine structures of massive international lenders like Citigroup and JPMorgan Chase. It's nearly impossible to shut down a U.S-based megabank with extensive overseas operations, they warn. Regulators will thus feel pressure to simply keep them alive.
One top FDIC official said the new bill, guided through Congress by Senate Banking Chairman Christopher Dodd (D-Conn.) and House Financial Services Chairman Barney Frank (D-Mass.), may not have made a difference when it came to resolving the fate of Wachovia, a firm that wasn't allowed to fail and instead was taken over by Wells Fargo. Wachovia's creditors were saved from losses.
"Taking the new rules, you all seem to have gained a lot of comfort with some of the new legislation that's passed about the ability that you will have in the future to be able to govern situations where firms may fail," Heather H. Murren, an FCIC commissioner who until 2002 was a managing director of global securities research and economics at Merrill Lynch, told Wednesday's panel of FDIC, Federal Reserve and former Treasury officials. "And I'm curious about what would have been different if you were to apply the rules that we now have today at the time when you were looking at situations like Wachovia.
"So then how would your body of knowledge have been different, and how might the outcome have differed had we had those rules instead of what we had at the time?" asked the former highly-ranked equity research analyst.
After a polite back-and-forth in which John Corston, the acting deputy director of the unit overseeing complex banks at the FDIC, explained the situation during those tense moments of the crisis when regulators were debating whether to allow firms to fail or bail them out, Murren finally asked: "So then the outcome might not have differed, it just would have been a little bit easier as you went along?"
"It might not have differed, but it certainly would have been -- I think we would have then made much more informed decisions," Corston replied.
Bair, his boss, was adamant that too-big-to-fail firms on the cusp of failure will be shut down in the future. Firms of systemic importance also will be required to present blueprints on how they'd be shut down should they approach failure. Bernanke and Bair both argued that this would have been invaluable during the height of the last crisis.
Bair said that companies that don't comply with the new rules -- or if regulators feel that some part of the firm poses too much of a threat -- will be forced to divest parts of the firm so that it "no longer creates undue risk to the financial system." Bernanke echoed that point during his testimony when he said regulators could make firms unwind to make dealing with their potential failures "feasible."
Given policymakers' proclivity for bailing out and propping up too-big-to-fail banks, though, questions remain as to whether they'll follow through on these threats.
"When it's crunch time, that's when the test will come," said FCIC commissioner Byron S. Georgiou. "A healthy skepticism about it is appropriate."
The commission's 43-page preliminary report on Too Big To Fail, released in conjunction with the two-day hearing, details the nation's recent history of bailing out massive banks and their Wall Street cousins, like hedge funds and securities firms.
During the Great Depression, the government rescued a number of large banks. But it didn't happen again until 1974, the report notes.
Then in 1980. And again in 1984 -- though this time, policymakers admitted outright that some firms simply were too big to fail.
"During a hearing on Continental Illinois's rescue conducted by the House Committee on Banking, Housing, and Urban Affairs in September 1984, Comptroller of the Currency C. Todd Conover stated that federal regulators would not allow any of the eleven largest 'money center' banks to fail," according to the FCIC report. "Representative Stewart McKinney of Connecticut, a member of the committee, declared that '[w]e have a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank.'"
The next day the Wall Street Journal headlined its piece on the hearing, "U.S. Won't Let 11 Biggest Banks in Nation Fail -- Testimony by Comptroller at House Hearing Is First Policy Acknowledgment." At the time of its failure Continental Illinois was the nation's 7th-largest bank, the FCIC notes.
Policymakers went on to rescue several large firms throughout the 1980s and the early 1990s.
Then Congress passed a law in 1991 attempting to end bailouts -- just like this year. It was useless during the most recent crisis, which saw two notable failures -- Washington Mutual, a lender, and Lehman Brothers, a securities dealer -- but several rescues of firms like Bear Stearns, another dealer; AIG, an insurer; the nation's biggest and smallest banks; and money market funds.
Because of the crisis, large firms swept up their almost-as-large competitors. JPMorgan Chase, for example, took over Washington Mutual, a $300-billion lender. At the time Wells Fargo took over Wachovia, the latter was the nation's fourth-largest bank.
"There's been a concentration of size and strength, obviously a disturbing trend," Georgiou said. "It doesn't give one a great deal of confidence" that regulators will be able to allow these firms to fail should they be near failure, he added, "but we hope for the best."
The last crisis, regulators and some academics stress, was a liquidity crisis -- there was a run on the banks. Money was no longer flowing, and so policymakers had to do whatever they could to ensure the markets didn't completely freeze, taking down the whole economy with them.
Others have argued that if one of the nation's largest firms runs into trouble -- a Bank of America, for example -- it's likely that because of the interconnectedness of the megabanks, BofA's failure would likely simultaneously cause the failures of other large institutions. Another crisis would ensue.
Asked if he thought regulators would be able to shut down one of the nation's largest banks if its failure could cause other big banks to fall, Douglas Holtz-Eakin, another crisis commissioner, responded with a question of his own: "Are you going to pull the trigger and wind down the six largest financial institutions simultaneously?"
The answer was clearly no.
READ the FCIC's report: