Reforming "Too Big To Fail"

Monday Morning Outlook
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Reforming "Too Big To Fail"
Brian S. Wesbury - Chief Economist
Robert Stein, CFA - Senior Economist

President Obama has recently made some proposals to deal with the banking system, including a tax on bank liabilities and limits on trading by firms with access to government-insured deposits or the Fed’s discount window.

Hopefully, this is not just a political pivot to shift the focus of populist ire away from his attempt to nationalize the health care system. Instead, the relationship between the government and the banking system needs to a serious discussion.

Failure is an essential part of capitalism. Ideally, no business would ever be too big to fail. If the key stakeholders in a company – shareholders and managers – believe the government will step in and save them in situations where the free market, left alone, would punish them, then excessive risk-taking is the natural result.

Think Fannie Mae or Freddie Mac, who ought to be the poster children for too big to fail. The promise of government backing means the cost of capital for these companies is, in effect, subsidized by taxpayers, giving these firms access to investment dollars that ought to go to other companies instead.

We would prefer that the government convincingly pre-commit to a policy of not saving financial institutions that fail. However, given everything that has transpired in the past couple of years, such a policy announcement would be greeted by laughter. No one would believe it.

As a result, the key issue for policymakers is not whether some banks are too big to fail, but who bears the cost of this status. The best solution is to change the way banks are regulated so the burden of getting too big to fail is carried by the same stakeholders who allow the company to get that way in the first place. Some regulator, perhaps the Federal Reserve – which tends to be relatively more isolated from political pressure – should have the discretion to certify if a financial company gets too big to fail or “TBTF.”

If the Fed designates a company as TBTF then some pre-set extra regulations should be triggered to make sure the bank does not take excessive risk at taxpayer expense.

For example, TBTF banks should have to meet higher capital standards than other banks and capital standards that fluctuate over the course of the business/financial cycle, so they are required during the “fat years” to prepare for the “lean years” that always have a way of returning.

These firms could also be required to deposit into escrow a certain percentage of worker pay (including bonuses) that could only be withdrawn gradually over a five to seven year period. Then, if the company eventually runs into trouble, there would be a pot of money available to deal with the problem before taxpayers would have to be tapped.

However, it is important to remember that every company should have a free choice about whether it wants to be in this position. Regulators would need to work with the banks to communicate when they are getting close to TBTF status, so banks know whether they are going to trigger this extra layer of regulation.

One key problem with President Obama’s drive to tax bank liabilities is that it would apply to many companies that are not particularly large, signaling investors that maybe some mid-sized companies are now TBTF. In other words, it casts the net way too wide. Another problem is that it’s based on a desire to raise revenue lost because of past policy mistakes, when it should be focused on preventing future policy mistakes.

Imposing extra rules on companies that are not TBTF would be an unneeded burden on free enterprise and will not save the taxpayers a dime. If shareholders and managers want to take huge risks and the taxpayer is not liable for losses, then there is no reason for the government to get in the way.