Too Big To Play Fair

The Federal Reserve just published a study which found that “too-big-to-fail” banks have an unfair advantage over other banks because of the threat they pose to the economy. They even posited some possible solutions. Unfortunately, they keep missing the real solution.

According to a series of papers issued by the Fed, the biggest banks benefit from lower funding and operating costs. “Funding costs” means what it costs them to borrow money, and as the papers found, it costs these banks less than other banks... about 0.31 percent less. That may not sound like much until you realize that (1) it is a statistically significant result (meaning there is statistical proof of favoritism), and (2) when you are talking about hundreds of billions of dollars, 0.31 percent can be huge.

Where this difference comes from is access to cheap taxpayer money and these companies being seen as less risky by other banks because the government will cover their debts. This is bad for our economy because it means these banks have learned to use the threat of their own failure to cop discounts. It also, according to the study, lets these banks take on much bigger risks than their peers, such as foreclosures, because they know the government will bail them out if they fail. That means they get to take unsafe risks on the basis that they get the profits if they are right and we take the losses if they are wrong.

As a not-coincidental aside, an industry group did what industry groups always do: they put out a counter study which found no difference between the too-big-to-fail banks and everyone else. Sure, uh huh, whatever. That's why only fools and talk radio believe industry anymore.

Unfortunately, the too-big-to-fail situation still exists. In fact, if anything, the problem has gotten larger as these huge banks continued to grow and absorb other banks. By now, both left and right are lamenting the fact that these companies are even more dangerous than before. That should be good for getting something done, but it hasn’t so far. What’s more, the regulators who have been put in charge of fixing this seem to be headed down the wrong paths. For one thing, they’ve ruled out breaking up these giant banks – the only true solution to “too-big-to-fail.” Instead, they’ve pointed to new rules requiring reduced leverage, holding more assets that can be sold quickly, and making less risky trades, but those changes are minor. They are also considering require these firms to contribute to a fund to cover future bailouts, which we know can never hold enough money for a true crisis. The FDIC also now has the power to seize a failing firm, replace the management and wipe out the shareholders, with the creditors becoming the shareholders. The problem with that, however, is that it doesn’t really discourage bad behavior because all the risk remains with the government.

Ultimately, the only way to solve “too big to fail” is to make each of these firms “too small to notice.” The fact these firms can use the threat of their own failures to get better treatment should itself send up red flags.

Sadly, the times they aren’t a changin’.