A Simpler Way to End Too Big to Fail

Oct. 19 (Bloomberg) -- Does size matter? When it comes to U.S. banks, the answer is increasingly yes.

Limiting banks’ size is a rare example of agreement among prominent Democrats and Republicans, who complain equally that U.S. banks have grown too big, too complex and too risky.

They also agree that big banks benefit unfairly from an implicit government guarantee despite the authority Congress gave regulators in the Dodd-Frank Act to dismantle troubled banks. (Does anyone really believe Washington would let JPMorgan Chase & Co. fail?)

Agreement tends to end there, however. Some officials, including Thomas Hoenig, a Federal Deposit Insurance Corp. director, and Dallas Federal Reserve President Richard Fisher, are pushing to break up the largest banks. Others, including Treasury Secretary Timothy Geithner, advocate bigger capital cushions so banks can absorb losses without a bailout.

So we read with interest about a new idea that has entered the mainstream, one that wouldn’t break up the big banks, which we’ve argued against, and instead would cap the size of their non-deposit liabilities. Such liabilities consist of borrowings from the Federal Reserve, commercial paper and -- perhaps riskiest of all -- overnight repurchase agreements, or repos, in which banks pledge their securities as collateral for overnight loans.

Limit Borrowings

Put simply, insured banks would have to limit such borrowings to a specific percentage of U.S. gross domestic product. The idea, floated in a recent speech by Dan Tarullo, the Fed governor most responsible for bank supervision, is worth considering.

A cap would force banks to shrink without government bureaucrats arbitrarily taking them apart. It would also curb banks’ continued reliance on the overnight loans that leave them vulnerable to runs, which is what helped bring down Bear Stearns Cos. and Lehman Brothers Holdings Inc.

Ohio Democratic Senator Sherrod Brown is proposing to limit non-deposit liabilities to 2 percent of GDP. Such a level would force the nation’s top five banks to shrink significantly -- possibly too much. A 2 percent cap would seriously crimp former investment banks such as Goldman Sachs Group Inc. and Morgan Stanley, which became commercial banks during the financial crisis and continue to rely almost entirely on non-deposit funding. A fee, instead of a cap, would be a more market-friendly alternative: Banks could be assessed a levy based on the size of their non-deposit liabilities.

Banks have grown too big. And non-deposit liabilities, not retail deposits, account for most of the growth in bank size since the mid-1990s. The five largest U.S. banks now control more than half of all U.S. banking assets -- nearly $9 trillion worth -- up from 17 percent in 1970. Non-deposit liabilities at almost all big banks exceed Brown’s proposed cap. JPMorgan has more than $982 billion in noncore liabilities (about 6.3 percent of GDP), according to data compiled by Bloomberg Industries. Bank of America Corp. has $889 billion (5.7 percent) and Citigroup Inc. has $816 billion (5.2 percent). Goldman Sachs and Morgan Stanley are at roughly 5.2 percent and 3.9 percent, respectively.

One reason banks have gotten bigger is that they are rewarded for size. Too-big-to-fail banks can borrow more cheaply than smaller banks, according to FDIC data, effectively handing large firms a government subsidy.

Dodd-Frank tried to address this with tougher capital and regulatory standards for banks with more than $50 billion in assets. The law appears to be working: A recent study by economists at the New York Fed found that investors are beginning to price in a higher risk of default on senior bonds issued by large institutions.

Special Status

Yet many economists and lawmakers say Dodd-Frank merely codified too-big-to-fail, effectively granting special status to large banks. In the first presidential debate, Republican nominee Mitt Romney referred to the Dodd-Frank Act as “the biggest kiss” to Wall Street banks.

That brings us back to the crux of the problem, non-deposit liabilities. As of 2008, there was about $2.8 trillion in outstanding repo borrowings. In March of that year, the five largest Wall Street investment banks were rolling over a quarter of their balance sheets every night, according to Princeton University economist Hyun Song Shin. Reliance on repos has since declined, although it’s still a $1.7 trillion overnight market.

Brown’s measure has the support of Alabama Republican Senator Richard Shelby, former Fed Chairman Paul Volcker and former FDIC Chairman Sheila Bair. Yet determining an appropriate cap could prove nettlesome. Why not 1 percent or 3 percent?

A fee would be better. Banks would be less likely to overborrow if they knew they would be charged a fee for every dollar of non-deposit liability. Such a levy would also bring money into the federal government at a time of fiscal strain. (A similar fee proposed by the Barack Obama administration as a way to recoup bailout costs was estimated to bring in about $90 billion over 10 years.) As with a cap, lawmakers would have to decide which liabilities to include and which deposits to exclude.

Valid worries persist about the risks large firms pose to the financial system. The incentives must shift so banks are penalized, not rewarded, for bigness.

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