A New Regime for Regulating Large, Complex Financial Institutions

1) Recent adjustments to our regulatory framework, including the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” have not fixed the core problems that brought us to the brink of complete catastrophe in fall 2008:

• a. Powerful people at the heart of our financial system still have the incentive and ability to take on large amounts of reckless risk—through borrowing large amounts relative to their equity. When things go well, a few CEOs and a small number of others get huge benefits—estimated at over $2 billion from 2000 to 2008 at the top 14 US financial institutions.
• b. When things go badly, society, ordinary citizens, and taxpayers get the downside, including more than 8 million jobs lost and a medium-term increase in debt-to-GDP of at least $7 trillion (roughly 50 percent of GDP).

2) This is a classic recipe for financial instability and fiscal calamity.

3) Our six largest bank holding companies currently have assets valued at close to $9.5 trillion, which is around 62.5 percent of GDP (using the latest available data, from end of Q3, 2011). The same companies had balance sheets worth around 55 percent of GDP before the crisis (e.g., in 2006) and no more than 17 percent of GDP in 1995.

4) With assets ranging from around $800 billion to nearly $2.5 trillion (under US Generally Accepted Accounting Principles, or GAAP), these bank holding companies are perceived by the market as “too big to fail,” meaning that they are implicitly backed by the full faith and credit of the US government. They can borrow more cheaply than their competitors—estimates place this advantage between 25 and 75 basis points—and hence become larger.

5) In public statements, top executives in these very large banks discuss their plans for further global expansion—presumably increasing their assets further while continuing to be highly leveraged. In its public statements, the US Treasury appears to endorse this strategy.

6) In this context, the Troubled Asset Relief Program (TARP) played a significant role preventing the deep recession of 2008–09 from becoming a full-blown Great Depression, primarily by providing capital to financial institutions that were close to insolvency or otherwise under market pressure. But these actions further distorted incentives at the heart of Wall Street. Neil Barofsky, the Special Inspector General for the Troubled Assets Relief Program put it well in his January 2011 quarterly report, emphasizing: “perhaps TARP’s most significant legacy [is] the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail.’”