PRUDENTIAL BANK DIVESTITURES

One of the key failures of the too-big-to-fail approach to systemic financial insolvency is its failure to stem economic catastrophe to any substantial extent. In fact, after the federal government rescued the reckless bankers from their self-created abyss, those same bankers proceeded to strangle the economy by hoarding capital and reducing lending. The chart illustrates the point. After the government expended vast sums to bailout the banks they reduced lending by 23% and hoarded capital at the Fed (where bank reserves soared). Meanwhile, massive capital flowed into the purchase of short term Treasury obligations (driving yields to zero and even into negative territory). This amounts to an historic flight to safety driven by severe risk aversion. This sudden reduction in credit led to GDP contractions of over 6% in both Q4 of 2008 and Q1 of 2009, the worst performance since 1947. The credit crisis caused the economic contraction, not the other way around. The bailouts thus failed. Therefore, avoiding the costs of too-big-to-fail in the future is the critical litmus test of any putative financial reform.

In a forthcoming law review article, entitled “Subprime Bailouts,” I argue that financial elites hopelessly distorted the government’s response to the recent financial calamity. More specifically, I suggest that our political leaders eagerly protected the financial elite from the harsh consequences of failing within a capitalist framework while leaving the taxpayer to pay the bill. Moreover, our leaders neglected the most compelling needs of our society in general, such as rendering aid to the victims of predatory lending or resolving the foreclosure crisis plaguing residential real estate.

I also articulate a minimalist solution to the problem of “too-big-to-fail” that is at the core of the issue. As I previously discussed on this blog, the Obama administration decided to formalize the actions of the Bush administration with respect to very large financial institutions; under both administrations the government ultimately stood behind such financial behemoths and expended trillions to keep them out of bankruptcy or FDIC receivership. Obama takes the Bush approach one step further: under the administration’s proposal the law would now explicitly empower regulators to extend special financial assistance for so-called “tier one financial holding companies.”

One simple solution to the “too-big-to-fail” quandary would be to empower a federal regulatory agency to monitor the systemic risk posed by any large financial institution and to order the divestiture of assets, divisions or particular operations if the financial institution poses a significant risk of requiring federal assistance under the proposal promulgated by the Obama administration. Government ordered divestitures already have a successful history ranging from AT&T in the 1980s to the Standard Oil Company at the turn of the century. Given the very costly bailouts of recent vintage, and the cratering of the economy in the aftermath of the bailouts, the government certainly has a compelling interest in the divestiture of financial institutions that threaten the entire global economy.

The administration’s proposed legislation currently includes a divestiture provision, in section 6A(f)(2)(F). That divestiture provision is only triggered if an affiliate nears insolvency or poses a significant threat to the financial holding company. The power to order divestiture should be expanded to permit regulators to order divestiture whenever a firm becomes or threatens to become too-big-to-fail. Regulators would consequently have the power of paring back any bank that even threatens to become too-big-to-fail. A single additional sentence could achieve this outcome. The solution proposed here supplements the approach of the Obama administration (and others). By focusing on systemic risk (rather than mere size) presented by a financial firm it is the most direct means of dealing with systemic risk. Creditors could not assume that any firm would remain too-big-to-fail and would therefore have the right incentives to secure repayment.

Such divestitures would be highly unlikely to harm shareholders as it could be accomplished through a spinoff of shares to shareholders. Moreover, even before the recent financial crisis there was little proof that these financial behemoths enjoyed real economies of scale. It appears that the real driving force towards concentration in the financial services industry is the elimination of competition and the compensation of CEOs, which increases with each empire-building acquisition.

The financial elite that benefits from the bailouts implicit in too-big-to-fail should support this proposal for prudential divestitures. The system of implied bailouts from a supposed principle of too-big-to-fail spawned enormous excess risk in the global financial system. Numerous firms looked into the abyss of insolvency, and global financial meltdown. Certainly, the outstanding leaders within the financial sector would appreciate the risks of artificially cheap capital flowing into large financial firms combined with an explicit “heads I win, tails you lose” legal framework. Such a system is inherently unstable, and could create enormous political backlash for far more punitive regulatory reform. Only an elite obsessed with short term profits would ignore the dangers of an unfettered too-big-to-fail legal regime. Such an elite ought not to assume that future calamities will operate as beneficially as the recent crisis in terms of their interests.

Professor Steven Ramirez

Loyola University Chicago