Too Big to Fail

What did the report assert?

The issue is "too big to fail." We have five extremely large institutions that are bigger now than they were before the panic in 2008 and 2009; that they have grown in size, that now have 52 percent of all of the deposits in the United States, and we have had greater concentration of banking power than before all of this started and before Dodd-Frank [Wall Street Reform and Consumer Protection Act]. So the issue is really, how do we deal with "too big to fail?"

Why are they bigger? What happened? I thought this was what Dodd-Frank was about.

First of all, even before Dodd-Frank, in reaction to the emergency of the failure of institutions, they were blended into these larger institutions, assisted by government in doing so.

Dodd-Frank's stated purpose is to end "too big to fail." It's in the preamble of the legislation, and it sets out -- in 2,000 pages and 400-and-some-odd sections -- various ways to deal with financial reform. The focus is supposed to be on making sure the taxpayer never again bails out these very large and complex institutions, and the issue is whether or not it will succeed.

Now it set up some new supervisory bodies that deal with different capital requirements for these banks, and by that what they mean is having sufficient depth of capital that if they get into trouble, they can draw on that capital to protect their depositors and to protect the taxpayer from having to go in and bail them out. …

We know the crises will reoccur. This has happened since the Mississippi Bubble and the Great Tulip Mania, or the South Sea Bubble. This is the nature of economies. …

The question is will the taxpayer be held hostage once more if we have such concentration within so few hands? Again, five banks, 52 percent of all of the deposits in this country. Is that healthy or not?

Our thesis in the Dallas Fed [Federal Reserve] is that this is not healthy. … It gives them such enormity of scale and complexity that it is very hard for regulators to penetrate that complexity. And I would argue -- having been a former banker in the real world by the way, not just at the Federal Reserve -- it makes them extremely difficult to manage because of their size and their scope. And risk management techniques, as it is known in the business, has become very formulaic and mathematical.

The old rule of banking was "know your customer." You shouldn't make a loan unless you know your customer, and you shouldn't really take their deposit unless you know their needs. There is no way on earth that these large institutions can know you or me or their corporate customers as they really should.

And there is a last thing, which is it mucks up the process of what we do at the Federal Reserve. We operate monetary policy. The banking system is an important cylinder in that engine. We provide the fuel. All of the cylinders need to work to operate efficiently. When they're struggling with assets that are in trouble -- even when we cut rates as we have done, or add to the money supply, the base, significantly, as we have by buying all of these covering securities -- they don't put them to work as efficiently because they are worried about their own problems when they get into trouble.

So there are several reasons why one has to be concerned about "too big to fail." The question is does Dodd-Frank answer and solve the problem or not?

And remember, we had hundreds of banks fail during the savings and loan crisis. We were the epicenter of that crisis, so we have been through it before. We do believe that it is one thing to say these new capital requirements, these new bodies that have been structured to deal with evaluating whether or not they are capital adequate, it's idealistically and intellectually attractive, but it may well be impracticable.

A better solution, we would argue, at lesser cost ultimately on the taxpayer, is to have these institutions downsized so that not one of them can place our system at peril, or together they cannot place our system at peril should they fail.

And so I guess that's the answer to the question, are we safer?

Well, it's not clear. We don't know yet. One thing we do know is we now have, I use this analogy: It's not really survival of the fittest; it's survival of the fattest. We have five gargantuan, obese institutions. …

Our argument is that it's not healthy to have a few obese institutions. I'd rather have a system where everybody is slim and fit and ripped and able to work their way through the system, provide the capital that's necessary for our business, for our entrepreneurs, for the women and men that run corporate America and also private business, small and large, to do what they do best: take risk, provide the credit for them, let them grow, create more jobs and create more prosperity.

How did they become so big? How did megabanks, superbanks get started? What happened?

Well, of course, you know laws changed, [the] Glass-Steagall [Act] was set aside. Really the genius who figured out the roadmap was Sandy Weill at [Citigroup]. And when he did the Travelers merger, it was opening brand new doors. …

Bankers have always been balance-sheet driven, meaning the security of their balance sheet gave the public the confidence to leave their money there. And they could also use their strong balance sheets to lend and provide the gasoline that fuels capitalism and economic expansion.

That's a different mentality [from] investment banks, which were there to underwrite securities and trade portfolios and take risk. They were income driven. … That's a different culture entirely. …

The injustice is when the taxpayer has to come in and dig them out. And I think that's given rise to both the Occupy [Wall Street] movement and to the End the Fed movement. … There is a sense of injustice here. And I think the best way to put it to rest is to make sure that we have a level playing field, that it's fair, and that we don't have these gargantuan institutions who are dominating the industry.

... Why? It seems to be to some extent that they were kicking the can down the road because of fear that they could create havoc within the market by looking into things too deeply. ... There was non-transparency, and to some extent one of the reasons for it is because they weren't asking for the material that they actually could have gotten their hands on. What was going on there? ...

... It was increasingly apparent that the deregulation environment that had been created by some of the same people who were now in jobs of responsibility, of supervising, advising the president-elect, they had created a system with a lack of transparency that made it very difficult to manage.

It was interesting that the role of ideology in economic models play in all this. Many of the economists who advised them believe that markets ... could manage risk, that the bank officers could manage risk on their own. They were very reluctant to have government interfere because that would interfere with the efficiency of the market.

What was so striking is that it should have been apparent that markets have repeatedly not managed risk. Markets just weren't invented in 1990, '95. We've had banks for a very long time, and banks have repeatedly mismanaged their risk.

But things have gotten worse because with the very large bank there is a problem economists call "agency," that the bankers, those who run the organizations, are rather distant from the shareholders and the bondholders. Their interests are quite disparate, and we've seen that. The bankers have done very well even though the shareholders and the bondholders have not done that well. ...

You look at the "too big to fail" banks, and you look at their incentive structures. They know that they're too big to fail, so if they gamble and win, they walk off with the profits. If they lose, they had a pretty sure bet that the taxpayer would pick up the losses. ...

If these are so impossible to manage, why did the banks want to grow to those sizes? ...

I think it's natural for any manager to want to grow his business. The question is at what rate, and in what direction, and in what format?

I don't think there's anything inherently wrong with a bank being big. In fact, there are some good arguments about universality of geography that in theory, if you have all your eggs in one little community, and some big employer goes out, that could be your downfall. If you're spread all around the globe, in that sense you could be mitigating risk.

But you could be a very simple bank and be spread around the world. What you're talking about is becoming a financial one-stop-shop supermarket.

I'm not a believer in the one-stop-shop supermarket. I think that every part of finance has become infinitely more sophisticated than it was before. I think narrower-focused activities really make more sense, because when you think about it, the Internet has now reduced the value of information practically to zero. So I believe it's going to ultimately drive the value of expertise to infinity, because everybody has information overload. ...

What accounts for banks banks becoming one-stop shops? Citigroup, Bank of America took on all sorts of different kinds of financial businesses.

We were always skeptical that that would work, and I think it has not turned out to work. Running an insurance company is not the same thing as running a retail bank. We don't think there's any logic in them being in the same entity.

The whole idea of it was cross-selling. The idea of if I've captured a person or a company as a customer in one of my activities, now I should be able to cross-sell them.

That doesn't really work, and the reason it doesn't work is the fellow who has the account relationship doesn't want to run the risk that some other part of the institution will screw it up. So cross-selling has never worked on a very big scale. ...

In fact, we find them betting against their clients.

Right.

I mean abuses really.

But some of that is hedging too. ... Again, I don't see anything wrong with people trading one direction or another. I think there are issues about fulsomeness of disclosure, but if a trading house wants to be short something and a client wants to buy it, I don't see anything wrong with that.

I think where it is a little bit wrong is if the client who's wanting to buy it isn't aware that the guy on the other side of the trade is shorting it to him. I don't think that's a necessary part of having markets. Now the client may want to go ahead and do it anyway, and that's fine. But I do think there are issues of disclosure.

There was a lot of talk about nationalizing banks. Citi was the prime candidate, but there was talk about Bank of America as well. First they were going to fire Ken Lewis, and then they were going to nationalize the bank. Would it have helped to fire Ken Lewis? … Would that have had any effect?

I would argue that in a sense, the "too big to fail" institutions were quasi-nationalized; that is, they were saved by either being given leeway to acquire institutions that they otherwise wouldn't have acquired, and also they were subsidized by the government in terms of monies provided to make sure they could have ongoing operations. And so these are bailouts.

Usually in the private sector, you go through Chapter 7 if you're a total disaster, or you go through Chapter 11 if there is hope for the company and it can be reorganized. And the bondholders take it in the neck, but the shareholders get pretty much wiped out. And typically what happens is management gets totally replaced. They messed up, they pay a price, they're let go.

That clearly did not happen in the case of any of the major financial institutions, large or small, that failed in this process.

Why?

Well, because we didn't let the private sector clear the system out of fear that doing so would lead to an implosion of the global economy and deflation. But I think we want to make sure we don't pervert capitalism from the standpoint of letting the market exert its discipline.

We argue at the Dallas Fed, and I argue personally, what makes this country great is what the economist named Joseph Schumpeter called "creative destruction." We are masters of creative destruction in America. If we weren't, we would still be a totally driven agricultural society for example. … That process of creative destruction applies in the rest of the private sector. It should apply in the financial sector, as well. …

Were there opportunities that we missed to accomplish this, especially when the banks were on the ropes, basically, because they were on the taxpayer dollar?

Well, it's easy to be armchair quarterbacks after the fact. But when you are in the midst of battle, when you're in the midst of a crisis, I think it's very hard to structure an entire system. Instead, you are putting out the fires.

But what we now have to do is rebuild the ecosystem of banking and make sure that we do have the firebreaks along the way. And rather than just fight those fires one after another as they come up, make sure they won't spread and burn down the entire economy.

But when you look back, the value of history, too, is to look back and say there were these moments.

I think the moment is now, because we are, as I said earlier, the system is liquid. Before, liquidity had disappeared. That's not the time to act. Secondly, the economy is strengthening. So we may not be quite strong enough. We argue at the Dallas Fed that one of the reasons we are not strong enough is because we're sort of being held to the sludge that's around the pistons that is the "too big to fail" institutions. But I'd rather do it now under conditions where liquidity is abundant. And I think now is the time to act. …

We've talked to executives from some of these banks, from Wells Fargo and some of these other "too big to fail" institutions. They say they were never really in trouble during the crisis, that they could have survived without government help. … Were they actually in trouble during the crisis? Were the largest five institutions, would they have survived without help from the government?

Well, the question is about would the five or more have survived without help from the government. There were different degrees of health, and I'll let them speak for themselves. I hear them saying that some felt compelled by virtue of the pressure put on them by the secretary of the Treasury, and by the New York Fed to participate. And the reason for that was to eliminate the stigma that might be associated. And indeed, some of these banks are better operated, have less risk than others. But in the end, they all decided to participate, that's a fact. …

Do you think that a bank holding company the size of Citigroup could be taken apart?

It is far more difficult than people imagine.

You're on the FDIC's resolution committee.

... One of the efforts being made by the FDIC through the whole so-called living will process -- and hopefully our committee has some input into this -- would be to make it easier to take apart a major bank if it runs into very deep trouble.

The single-biggest flaw, in my view, which was exemplified by the 2008 crisis is there was no game plan. There was no break-the-glass-in-case-of-fire little pamphlet which said here's how we're going to do it. ...

Every decision was ad hoc, under extraordinary time pressure, and the best people in the world are going to make less than optimal decisions in those cases. ...

But are we safe if we can't figure out a way to take down a big bank if we remain with this "too big to fail" problem?

... We've got to end too big to fail, and the way to deal with that is to have multiple options and to have them analyzed in advance.

Personally I think the best way would probably be to go through a recapitalization arrangement. Go to the creditors and say, "If we will turn your debt into equity, will you come in?"

It will not be done as a living bank. The bank will be failed. The company will be failed. It will be taken into resolution. The bad parts will be left behind. The good parts will be available for recapitalization.

It gives the creditors the opportunity to take their chances on the bad bank, or to turn their interest into equity in the good bank. And you would go what I would call a stack, so subordinated debt comes first, long-term debt second, and that will almost certainly be enough.

There could also be the option of bringing in private equity, new forms of capital for this institution.

You have to have the option of selling pieces, but all of this all these options need to be available and thought through ahead of time. This is a critical problem, and it's critical I think for reasons not fully understood. ...

Why is untenable to treat them like utilities, require double the kind of capital requirements that are now going to be in place?

... The difference is utilities are almost all monopolies, and utilities also are not in the risk-taking business.

Banks are in the risk-taking business; that's what banking is all about. Banks take at least three major types of risk. They take credit risk. If they're not willing to take credit risk, we don't have a well-functioning economy. They take counterparty risk, as money has to move from party to party. And they take what I would call asset liability risk, because most funders are short and most uses of capital are long, so banks have to bridge that.

There's a difference, obviously, between excessive, undue risk on one hand, and appropriate risk on the other. But one argument that I always use when this question comes up is would you want a bank never to have a bad loan? I would say if you have such a bank, that bank would not be making a lot of good loans. ...

We still haven't seen results in the economy even though the banks have been given billions of dollars to loan. We still have banks that are too big to fail, that are systematically risky institutions. What progress have we made?

There has been progress in raising bank capital levels and requiring that they rely more on long-term funding, so they are more stable from that standpoint. ...

Europe hasn't done much of anything to stabilize their banks.

But we're tied to this banking system. It's all one banking system.

We are. That is true. ... I have done as much as I can -- and probably made myself unpopular with a lot of people in Europe -- to try to bring more public attention to that. Because I don't think the problem with regulatory capture is much worse in Europe in that there is just no separation between the big banks and their regulators. It is a very close relationship and one that I wish the political leadership in Europe would look more closely at, because I think that's a real problem.

But we have made progress. I think the lending standards are better. The Fed did finally move ahead, at least with the high-risk mortgages, and have lending standards across the board.

But we still have "too big to fail."

But there has been progress there too. There are tools to resolve these institutions now. There's been internal planning at the FDIC to be able to put them in a resolution should one of them get into trouble. They are now required to do plans to show how they can be disassembled. ...

... But we still have a system that looks to me [like] we could be back where we were in 2008.

That it could change on a dime? You're right. We absolutely could be.

I think the lack of tangible progress is frustrating to people. I'm not going to say what's happened is near enough. It's not near enough. But in fairness to the regulators, capital is much higher. Liquidity, the funding of banks is much more stable. I think there has been significant improvement there.

We need to be vigilant. They're backsliding already on their funding structure and funding with long-term debt, but there have been improvements there.

In March of 2008, before Bear [Stearns] goes down, or is sold to JPMorgan Chase, you said that we're going to have a lot of bank failures. The bubble was about to burst.

Right. They were.

You said: "I think it's the medium-sized banks, particularly some of those that got overextended with the subprime and other kinds of mortgage debt. Those are the ones where there's going to be a problem." You said that the big banks won't fail in the sense that I think the Fed and other regulators will make things happen.

I think that's pretty much what did happen.

How did you know? You saw that they were in a sense too big to fail? ...

First of all, we felt they were too big to fail. But second of all, the failure of a medium-size bank that's going to cost FDIC [Federal Deposit Insurance Corporation] $100 million or $200 million or $500 million is affordable.

The systemic risk of a Bank of America failing, a JPMorgan, someone of that ilk, probably the whole system couldn't afford. And we just felt that the government would understand that and would do something.

Now at the time, we had no idea about TARP [Troubled Asset Relief Program] or any of these other things that would come, so I had no idea what the form would be. But it seems pretty clear that if we were right, that the subprime thing was going to blow up, the government would draw the line at the really big institutions.

... The taxpayer would be on the line for any speculative trading they did in these big banks. ...

Exactly, and that's what turned out to be the case. What you had was a socialization of private sector errors into eventually public sector debt.