Monday, July 20, 2009

Obama's Too-Big-to-Fail Failure

On July 9, 2009, Gary Stern, the President of the Federal Reserve Bank of Minneapolis, gave a little-noted speech to the Helena Business Leaders in Montana. Stern suggested that the Obama Administration’s recent proposal for financial reform “fails to deal adequately with the too-big-to-fail problem and therefore, unless strengthened, will leave the financial system susceptible to future bouts of resource misallocation and serious instability.” Stern explains: “there is nothing in the [Obama] proposal designed to put creditors of large, systemically important financial institutions at risk of loss.” So, under the administration’s proposal, creditors may assume that our largest financial firms are now legally deemed too-big-to-fail and that they will consequently be protected by the government in the event such a firm becomes insolvent. Stern is not the only voice raising objections to the approach of the Administration to financial institutions that are supposedly too-big-to-fail.

MIT economist Simon Johnson maintains that the financial sector used its prodigious political muscle to maintain its too-big-to-fail umbilical cord to the United States Treasury. According to Johnson: “The government blinked in the face of financial sector complexity and scale. ‘Too big to fail’ is ‘too big to exist,’ but the president’s document goes nowhere near this fundamental principle.”

The question is simply this: can we tolerate a financial sector that privatizes profits (particularly in the form of huge payouts to CEOs) but socializes losses? That is the upshot of the Obama “reform” plan. It hard-wires “heads I win, tails you lose” into our financial regulatory system for CEOs, at the expense of the U.S. taxpayer, on a permanent basis. It creates perverse incentives for financial firm executives to take greater risks to beef-up current profits (and especially their own compensation) without respect to future losses which are absorbed by the taxpayer. Creditors will no doubt be attracted to the government guarantee applicable to these firms and therefore will provide them with cheap capital. Thus, every financial firm will rationally seek to become too-big-to-fail, so that they too may gamble for big paydays with cheap money while leaving the losses to the U.S. taxpayer.

Such a financial system is doomed to failure, under the crushing burden of excessive risk. Moreover, the very regulators that missed the subprime fiasco are not likely to exercise sustained regulatory oversight to control these risks.

The Treasury proposal includes a “special resolution regime.” Under this regime the Treasury would have power (after consulting with the President and subject to approval by the Federal Reserve Board as well as the FDIC to “stabilize a failing institution (including one that is in conservatorship or receivership) by providing loans to the firm, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm.” The Treasury is obligated to consider: “the effectiveness of an action for mitigating potential adverse effects on the financial system or the economy, the action’s cost to the taxpayers, and the action’s potential for increasing moral hazard.” Further, the Treasury proposes to empower the Fed explicitly now to use its power to lend to avoid the “disorderly failure” of any financial firm, subject to approval from the Treasury.

This amounts to nothing less than the formalization into law of “Ersatz Capitalism,” which is terminology used by Nobel laureate Joseph E . Stiglitz to describe the “privatizing of gains and the socializing of losses.” He like Professor Johnson argues that it is time to break-up big finance, “vertically and horizontally.”

Too-big-to-fail is already a known failure. The concept created perverse incentives that contributed directly to the entire subprime debacle. To the extent firms suspected that they were immune from the unpleasantries of bankruptcy or FDIC receivership they had the incentive to take the inordinate risks that formed the foundation of the subprime debacle.

The cost to the taxpayer is up to 12 trillion dollars and counting, according to an analysis from the Chicago Tribune of all the expenditures and commitments of the U.S. government. If only half of that amount ultimately is expended, that will total about $20,000 for every man, woman and child in the United States. Of course, the politicians hope that the voters are too ill-informed to figure out the vast wealth being transferred to the financial titans. It is the most massive transfer of wealth from the disempowered to the powerful in history.

Going forward, we can avoid a repeat of this nightmare simply by outlawing firms that are too-big-to-fail, breaking them up, and forcing them into a resolution regime like that of the FDIC if insolvency occurs. The FDIC exists to liquidate insolvent banks (which are typically placed into receivership) and protect primarily depositors. After all, the FDIC took control of Continental Illinois in 1984, then the seventh largest bank in the country. During the 1980s, the government took control of literally thousands of insolvent banks and savings and loans. More recently, Washington Mutual, then the largest thrift in the nation was seized last September, and immediately resold, with no cost to the government backed insurance fund.

Of course, bank managers would not fare well under FDIC receiverships. They are typically replaced and often sued for breach of fiduciary duty. Unsecured creditors and shareholders also fare poorly. Usually there are insufficient funds to pay-off much more than depositor claims and the claims of the FDIC as receiver and deposit insurer when a bank faces insolvency. FDIC receiverships terrify senior management and unsecured creditors.

This explains why the Obama proposal includes the legal formalization of too-big-to-fail. The administration included bank executives and lobbyists in its deliberations on financial reform. Nor, is there much hope that Congress will right this ship: according to Senate majority whip Dick Durbin, the banks “own the place.” According to Congressman Collin Peterson they merely “run the place.” Many experts have formulated various alternatives to massive subsidies for the most powerful firms in our economy; but, their brilliance apparently cannot fund a political campaign. In Switzerland, the regulatory authorities are threatening to break-up banks that are too big to fail. Small is beautiful for banks.”

There are other flaws with the administration’s proposal that similarly reinforce the very same distorted incentives that caused the subprime debacle. So, unless our lawmakers suddenly come to their senses, brace for Subprime Debacles II and III and IV . . . and so on. The system will now be hard-wired for reckless banking. After spending trillions in bailouts, the Administration’s proposal to ensconce too-big-to-fail in law is tantamount to telling taxpayers: “Keep that checkbook open!”

Professor Steven A. Ramirez

Loyola University Chicago

School of Law

July 20, 2009


  1. Professor Ramirez is correct. The Obama regulatory reform plan does not adequately address the issue of "moral hazard." In essence, if the govenrment stands in place to insure the risky behavior and judgments of financial institutions concepts of moral hazard and sound risk assessment are negated. If we continue to follow a too-big-to-fail policy we are likely to see more frequent or cyclical economic downturns. Will our economy be back in a similar situation in a decade?

  2. professor ramirez:

    this is a powerful post. and it is absolutely frightening. what can be done to motivate this administration and congress to place responsibility for failure where it belongs? at the feet of those that manage the failure.

  3. yesterday, peter orzag commented that we as a nation have, paraphrasing, backed off of the brink of the economic meltdown. it appears that corporate America would have us believe that the markets are rebounding and that we can put our faith back into the capital markets and those that manage our financial institutions. this with unemployment wreaking havoc on the lives of millions of americans and trillions of dollars being committed to steadying the financial system in the united states.

    privatizing profits and socializing losses/ failures as described in this post is offensive and an affront to democratic principles.

    for those critical of Obama and his policies, including those that charge his administration with advocating "socialism," must be careful that their hypocrisy does not shine through. gladly accepting government bailouts for managing a corporation into the ground (or advocating for future bailout protections) and then criticizing health care reforms as socialist are two positions that simply do not square.

  4. The too-big-to-fail approach made some sense initially. The downturn may have been even worse if certain institutions were left to fail. Living in Manhattan, I see first hand the ripple effect that occurs when big business disappears. The economies of some of our large cities are impacted when institutions fail, and this impact is felt by the middle and working classes who provided goods and services to the failed institution.
    But, the too-big-to-fail-approach makes no sense, as Steve Ramirez writes, as an ongoing policy. In addition to the proposals in his post, policy makers should continue to grapple with the difficult issue of limiting executive compensation for those who work for companies that are rescued by taxpayers.