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  • Too Big to Fail: Brown–Vitter Swings and Misses

    bank-of-america-times-square

    Newscom

    In an unusual left–right pairing, Senators Sherrod Brown (D–OH) and David Vitter (R–LA) last week introduced legislation to increase capital requirements on large banks. Calling it the “Terminating Bailouts for Taxpayer Fairness” or TBTF Act, the legislation is aimed at ending another TBTF: the doctrine of “too big to fail.”

    The target is a worthy one: The idea that some financial institutions must be supported by the government rather than be allowed to fail is toxic to markets and costly to taxpayers. But Brown and Vitter’s plan is the wrong instrument for the job, one that could do harm to the banking system while failing to ensure the end of too-big-to-fail.

    The frustration that has led to Brown and Vitter’s proposal is understandable. Three years after passage of the Dodd–Frank financial regulation bill and its promise of an end to bailouts, it is still widely assumed that regulators would step in to prevent the failure of a bank considered systematically important. That frustration has already led to calls for the outright breakup of the biggest banks into smaller pieces.

    Brown–Vitter stops short of that, instead requiring banks to maintain outsized capital levels: 15 percent for banks with $500 billion or more in assets and 8 percent for banks in the $50 billion to $500 billion asset range. These levels far exceed those mandated under the “Basel III” standards crafted by international regulators over several years. The Brown–Vitter requirements are also far blunter than Basel, for instance, dispensing with differentials for different types of capital based on risk levels. The sponsors tout the proposed requirements as “simple and easy to understand,” but given the complexities of the modern banking system, simple rules just for simplicity’s sake may not be the best.

    Few dispute the need for some capital standards. But standards that are too restrictive can cause harm, as they take lending capacity out of the banking system, and reduce funds available for businesses that need resources to grow. Some observers, in fact, view the Brown–Vitter capital levels as so restrictive that they amount to a backdoor breakup of the banks.

    At the same time, the Brown–Vitter plan fails to end too-big-to-fail. Despite the name, too-big-to-fail has never been justified on size alone: Smaller firms that are highly interconnected or otherwise considered key have also enjoyed implicit protection. Brown–Vitter does nothing to address these entities.

    There is a better solution. Rather than massive increases in capital mandates, policymakers should focus on making the failure of a large financial institution less damaging to the economy at large. The Dodd–Frank law attempts to do this through its “Orderly Liquidation Authority,” although that procedure provides too much discretion to regulators in disposing of assets. But other approaches based on existing bankruptcy law show promise.

    Too-big-to-fail and the market distortions it causes should be ended. The Brown–Vitter proposal rightly raises the alarm about these problems but misses the mark on a solution.

    Posted in Economics [slideshow_deploy]

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