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Banking’s ‘Toxic Cocktail’ Is Too Big to Forget: Simon Johnson

As a senator from Delaware in 2009- 10, Ted Kaufman fought long and hard against the systemic dangers posed by large, highly leveraged U.S. banks. When he left the Senate, at the end of the last Congress, there were some who supposed that his arguments would now get less attention at least from mainstream thinking.

But far from dying out, the points Kaufman made seem to have taken hold within influential government circles.

The latest quarterly report from Neil Barofsky, the special inspector-general for the Troubled Asset Relief Program, is the best official articulation yet of why too big to fail is here to stay. In its executive summary, the document, which was released this week, discusses “perhaps TARP’s most significant legacy, the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail.’”

This reasoning builds on evidence presented in Barofsky’s recent report on the “Extraordinary Financial Assistance Provided to Citigroup Inc.” But it goes much further with regard to the general policy issues we now face. Barofsky credits Henry Paulson and Timothy Geithner with making it clear that TARP funds would be used to prevent any of the country’s largest banks from failing during the global financial crisis and thus “reassuring troubled markets.”

‘High-Risk Behavior’

But the very effectiveness of Treasury actions and statements in late 2008 and early 2009 had undeniable side effects, “by effectively guaranteeing these institutions against failure, they encouraged future high-risk behavior by insulating the risk-takers who had profited so greatly in the run-up to the crisis from the consequences of failure.”

And this encouragement isn’t abstract or hard to quantify. It gives “an unwarranted competitive advantage, in the form of enhanced credit ratings and access to cheaper capital and credit, to institutions perceived by the market as having an implicit Government guarantee.”

Of course, the Dodd-Frank financial-reform legislation was supposed to end too big to fail in some meaningful sense. But Barofsky is skeptical -- and with good reason. Our largest banks are now bigger, in dollar terms, relative to the financial system, and relative to the economy, than they were before 2008. So how does that make it easier to let them fail?

Big Gets Bigger

At the end of the third quarter of 2010, by my calculation, the assets of our largest six bank holding companies were valued at about 64 percent of gross domestic product -- compared with about 56 percent before the crisis and about 15 percent in 1995. Barofsky quotes Thomas Hoenig, president of the Kansas City Federal Reserve, who uses similar numbers and draws the same conclusion: The big banks have undoubtedly become bigger.

Today’s increasingly complex megabanks are global. Their potential collapse can’t be handled within national resolution or bankruptcy frameworks, and there is no chance we’ll get an international agreement on how to handle these issues any time soon. I find relevant economic officials from a wide range of countries increasingly agree, at least in private, with the arguments made in this respect by Kaufman and some of his colleagues (including Senator Sherrod Brown of Ohio).

According to the Barofsky report, the Federal Deposit Insurance Corp. under Chairman Sheila Bair seems to be willing to take this assessment to its logical conclusion -- to force megabanks to simplify their operations and divest themselves of some units, if this is what it takes to make orderly liquidation a feasible option.

Freedom of Action

Unfortunately, there is no sign that the Treasury Department is inclined to move in that direction. The quotes from Geithner are all about preserving his freedom of action in future crises, including the ability to determine that any financial institution is “systemic” and needs to be protected.

The Federal Reserve remains completely on the fence. On the one hand, Chairman Ben Bernanke is capable of clearly defining the problem. Firms perceived as likely to be saved by the government, according to Bernanke, “face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.” On the other hand -- although it isn’t in the report -- all indications suggest the Fed isn’t taking a tough line with big banks.

Ted Kaufman was right to worry about the large lenders. His ideas have gained lasting traction, and the debate among officials shows promise. But the situation still is dire. The incentives for large private banks are now as distorted as those that faced Fannie Mae and Freddie Mac, which had too little capital and took on too much risk when they had an implicit government guarantee (though efforts to pin the crisis of 2008 on those institutions are misplaced.)

As the Barofsky report puts it, “TARP has thus helped mix the same toxic cocktail of implicit guarantees and distorted incentives.”

Simon Johnson, co-author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown” and a professor at MIT’s Sloan School of Management, is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Simon Johnson at sjohnson@mit.edu

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net

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