TBTF and the $7 Trillion Question

The Wall Street Journal ran a disturbing story this weekend. The story featured Thomas Hoenig, President of the Federal Reserve Bank of Kansas City. He adds yet another angle on Dodd-Frank and the TBTF problem.

According to Hoenig, a handful of megabanks hold over $7 trillion in derivatives exposure--a number that dwarfs all other sectors combined. Hoenig argues that the concentrated nature of this exposure means that the megabanks cannot be permitted to fail because the failure of one would still cause the entire financial sector to collapse as each bank would have to write off the amount owed by other banks under derivative agreements.

"Mr. Hoenig doesn't buy the idea that better supervision, higher capital levels and powers granted by the Dodd-Frank Act to wind down a tottering institution will take care of the too-big-to-fail problem. The biggest firms, he noted, can't be wound down because 'there are too many connections that will bring down other institutions.'"

I have long argued that Dodd-Frank did not end TBTF, but instead institutionalized it. Hoenig highlights another reason why that is so. The only remaining question revolves around the behavior of the derivatives markets if oil surges, prompting a nasty bout of stagflation that could well cause losses to the financial system that feed into the derivatives markets and land who knows where.