The Cost of Not Fixing the Financial System

The Problem

1. The underlying fiscal problems of the United States have significantly worsened as a direct result of how the financial crisis of 2008-09 was handled.
    
2. The US economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small or medium-sized financial institutions. A large number of these institutions have failed so far this year, without causing major disruption to the economy.
    
3. The United States does not yet have a similarly effective way to deal with the insolvency of large financial institutions. The dire implications of this gap in our system have become much clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table. In fact, our underlying banking system problems are likely to become much worse.
    
4. The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks. However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the US and global economy. The prospect of such disruption, they reason, would induce the government to provide various forms of bailout. They also invest considerable time and energy into impressing this point onto government officials, in a wide range of interactions.
    
5. Even more problematic is the underlying incentive to take excessive risk in the financial sector. With downside limited by generous government guarantees of various kinds, the head of financial stability at the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.” The implication is repeated bailout and fiscal stimulus-led recovery programs.
    
6. The implementation of the Troubled Asset Relief Program (TARP) exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.” This lowers their funding costs, enabling them to borrow more and to take more risk. The consequences include a contingent fiscal liability—both for specific bank rescue measures and, on a larger scale, the fiscal stimulus needed to offset a potential future credit crisis.
    
7. US national debt will increase substantially as a result of direct bank bailouts and, more importantly, the discretionary fiscal stimulus needed to keep the economy from declining—as well as the standard deficit due to cyclical slowdown (a feature of the “automatic fiscal stabilizers”). Privately held net government debt will increase from around 40 percent of GDP to 70-80 percent of GDP.
    
8. If any country provides unlimited government support for its financial system, while not implementing orderly bankruptcy-type procedures for insolvent large institutions, and refusing to take on serious governance reform and downsizing for major troubled banks, it would be castigated by the United States and come under pressure from the IMF. Yet this is the approach that the United States has implemented.
    
9. At the heart of every crisis is a political problem—powerful people, and the firms they control, have gotten out of hand. Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout. That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term. Again, this is the problem in the United States looking forward.
    
10. The Obama administration argues that its regulatory reforms will rein in the financial sector in this regard. Very few outside observers—other than at the largest banks—find this convincing.

Towards a Solution

1. As legislation on restructuring the banking industry moves forward, attention on Capitol Hill is increasingly drawn to the issue of bank size. Should our biggest banks be made smaller?
    
2. There is a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits. This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”
    
3. This cap was set at an arbitrary level—as part of the deal that relaxed most of the rules on interstate banking—and it worked well (until Bank of America received a waiver).
    
4. Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy. Of course, there are technical details to work out—including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would be the benchmark around which all the specifics can be worked out.
    
5. What is the right number: 1 percent, 2 percent, or 5 percent of GDP? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.
    
6. A hard cap at 4 percent of GDP seems about right for a bank with the most conservative possible portfolio. This would mean no bank in our country would have no more than about $500 billion of liabilities, even with a relatively low risk portfolio. On a risk-adjusted basis, most investment banks would face a cap around 2 percent of GDP.
    
7. A large American corporation would still be able to do all its transactions using several banks. They would even be better off—competition would ensure that margins are low and the banks give the corporates a good deal. This would help end the situation where banks take an ever-increasing share of profits from our successful nonfinancial corporations (as seen in the rising share of bank value added in GDP in recent decades).
    
8. Indeed, the whole world would soon realize that our banks are more competitive and offer better pricing than others.
    
9. If, as might occur, the Europeans subsidized their big banks with cheap finance and implicit subsidies, the United States should let our nonfinancial corporates benefit and understand that our banks may become ever smaller. We can let Europeans subsidize banking because we all get better deals through their taxpayer subsidies, and then our corporates will have more profits to bring back to America.
    
10. Today our politicians and regulators lack credibility. They have bailed out too many banks and need to show they have truly regained the upper hand—by showing that they are installing such a hard size cap rule without exception.
     
11. The litmus test is simple. Does Goldman Sachs continue to grow, and continue to be regarded as almost as good a risk as the United States government (Goldman’s Credit Default Swap spread is currently around only 70 basis points above that of the United States), because it has demonstrated it is too big to fail? Or, will the government impose a cap on the size of such institutions and require Goldman Sachs to find sensible ways to break itself into pieces—becoming small enough so that it will not be bailed out again next time?

In the Absence of Real Reform

1. Real progress towards reducing the risks inherent in the US financial system is unlikely. As long as there are financial institutions that are Too Big To Fail, we face a potential fiscal cost. We should recognize this in our government budget and balance sheet accounting.
    
2. The overriding principle behind IMF fiscal assessments is the need to capture true total fiscal costs. Best practice for the United States needs to reflect this approach.
    
3. All subsidies and taxation—including the entire cost of supporting the continued existence of large banks—should be reflected transparently in the budget and subjected to the prioritization of the budgetary process.
    
4. Our current accounting for guarantees and governments’ assumption of other contingent liabilities create the impression that government actions to support the banking system are costless. This is a dangerous illusion—as seen in the recent increase in US federal government deficit and debt.
    
5. If we don’t recognize these costs explicitly, we run the risk of taking on ever more contingent liability. If the financial system reaches the point where its failure cannot be offset by fiscal (and monetary) stimulus, then a Second Great Depression threatens.
    
6. Next time, we cannot be certain that the available size of fiscal stimulus—either in the United States or worldwide—will match the negative shock to demand caused by the credit crisis. Either we will already have too much debt or we will be constrained by the consequences of taking on even more debt. Or—just as in 1930—the financial decelerator will simply be too large to be offset by any feasible fiscal measures.

This post was also posted on Simon Johnson’s blog, Baseline Scenario. It is a slightly edited version of remarks prepared for delivery at Unwinding Public Interventions in the Financial Sector: Preconditions and Practical Considerations, IMF High-Level Conference, Thursday, December 3, 2009, Washington D.C.

Following was previously posted on Baseline Scenario:

Feudal Lords of Finance (December 2)

In some influential circles, these questions are now asked: What’s wrong with high levels of inequality in general, and with having very rich bankers in particular. After all, human societies have survived the presence of extremely wealthy individuals in the past—in fact, some now argue, the presence of such a “new aristocracy” can finance growth and spur innovation.
This argument is deeply flawed along three dimensions.

1. Such super-elites care very little for anyone other than themselves. Certainly, there will be some charity—but remember that John D. Rockefeller’s greatest donations came after he had been dragged through the mud by some very persuasive rakers (Ida Tarbell).
    
2. It is a mistake to assume that any country’s institutions (the laws, rules and norms that govern behavior) are fixed for all time. In reality, institutions change all the time—partly in reaction to who has wealth and power, and what they are trying to do. What are the odds that our financial super-rich will want to build democracy and strengthen the middle class?
    
3. Can the rich and powerful really be counted on to save the system, or just themselves? Go back carefully through the early history of the Great Depression (see Lords of Finance). Certainly the big New York players saved banks and securities firms that were seen to be part of their club (e.g., Kidder Peabody), but they—and the New York Fed—were not so inclined to save financial institutions they regarded as less than central (e.g., Bank of the United States), even if this meant thousands of people lost their life savings.

When the Bank of England’s Andrew Haldane speaks of a “doom loop,” he is describing the declining future for our middle class. Powerful financiers, by and large, did just fine during the Great Depression.