Way Too Big to Save

Listening to US officials, talking to legal experts, and waiting for an intense Senate debate on financial reform to begin, you can easily form the impression that "too big to fail" adequately describes our most serious future systemic banking problems. It does not.

In September 2008, the large banks and quasi-banks at the heart of our financial system faced failure -- and they were saved in the most immediate sense through actions taken by the Federal Reserve, but TARP (passed by Congress and run Treasury) also played a significant supporting role.

The Bush administration threw a small fiscal stimulus into the mix in early 2008, hoping to stave off recession; the Obama administration committed a much larger package at the start of 2009, aiming to prevent anything like a Second Great Depression. This fiscal policy response was in direct reaction to problems caused by the overextension and near failure of the financial system

Do not make the mistake -- for example of Secretary Geithner, talking to the New Yorker -- of thinking (or implying) that "saving the financial system" did not involve spending a lot of taxpayer money to support the real economy. Remember that if the economy crashes, asset prices fall, and banks' problems become even more severe.

And try to avoid three further mistakes that are currently common.

1. "Because the government will lose little on its TARP capital injections into banks, the financial rescue ends up not being costly." The true fiscal cost arising from our recent financial excesses is the increase in net government debt held by the private sector. This will likely amount to around 40 percentage points of GDP (i.e., relative to what the Congressional Budget Office's baseline would have been otherwise). That's a huge fiscal cost.

2. "Deficits don't matter." Eventually deficits matter -- the fiscal costs incurred in saving our financial system mean higher taxes, relative to what would otherwise have been the case, for you and your children. This is not a call for precipitate fiscal austerity; that would be a disaster. But eventually we will get our fiscal house in order - and then don't send to know for whom the tax bell tolls; it doesn't doesn't tinkle for Hank Paulson.

"We can save our financial system in the future, if we have the right tools - in the form of an appropriately designed resolution authority."
  • Such an authority is impossible to achieve, because it would require cooperation between governments (known as a cross-border resolution authority) and that is impossible. (If you don't know why, here's the explanation.)
  • Even if you had an authority that worked, e.g., for purely domestic financial entities, it is a leap of faith to assume it would not be compromised by our political process (again, more background explanation here.)

Let's take that leap of faith and say we use the favorite scheme of Gerald Corrigan from Goldman Sachs -- he is widely promoting conservatorship as a transition to wind-down for large complex financial institutions -- and let's say that it "works". Presumably this would mean something like the situation with AIG since September 2008, run somewhat more effectively -perhaps without the obnoxious bonuses. But would that really lower the fiscal costs of stabilizing the economy in the face of a major financial shock? And could we afford those fiscal costs?

Maybe. But the experience in Europe is definitely not encouraging. The Irish state is in serious trouble because major banks failed and were "saved"; let's not even talk about Iceland (where banks assets peaked around 11-13 bigger than GDP, i.e., the size of the entire economy). And Switzerland faces serious risks -- with banks that had peak assets over 8 times GDP -- that the international community apparently just wants to ignore (perhaps because Switzerland is not in the G20 or the even the European Union).

In the UK, one bank (RBS) had assets that were more than GDP (1.25 times, by some estimates). Ask yourself this: if Citigroup, which was around $2.5 trillion before the crisis (including the off-balance sheet commitments, let's call that just under 20 percent of GDP) had actually been $5 trillion, would our problems now be larger or smaller? What if Citigroup -- or whoever becomes our biggest bank -- reaches $10 trillion or $15 trillion in today's dollars and then fails, how would you feel about that?

The administration proposes -- in one part of the Volcker Rules -- to cap the size of individual banks relative to total nominal liabilities of the financial system. That makes no sense at all -- go talk to the Irish, the British, the Swiss, or the Icelanders (when they become less furious and are willing to talk).

Big banks have a funding advantage -- the implicit government guarantee makes it easier for them to raise capital and cheaper for them to borrow money. They will become larger. There are no economies of scale in banking above $100 billion in total assets, but this is not about economics. It's the politics of becoming large in order to become even bigger -- building your empire, and paying yourself and your people a lot more money (in the good times) and making it more likely your fiefdom survives (in bad times).

The biggest banks in some European countries today are already too big to save. Unless we take immediate and real action to reduce the power -- and size -- of our largest banks, we are heading in exactly the same direction.

Is the Senate finally ready to address this issue?

Cross-posted from The Baseline Scenario.