Tag Archives: “too big to fail”

03.16.2013 | Too Big To Fail: The Volcker Rule or Glass Steagall?

It will be tough to remedy “too big to fail” with the Volcker Rule. At the other extreme, some suggest a 2013 version of Glass-Steagall. Here is the short version of the facts:

Proposed by former Fed Chair Paul Volcker, his rule was expressed in 10 pages of the Dodd Frank Wall Street Reform and Consumer Protection Act. Essentially the Volcker Rule said that banks could no longer engage in proprietary trading for their own account because it created too much risk.

But, what does proprietary trading mean? We can start with the trading that former and current Chase executives described to the Senate Investigations Subcommittee during testimony yesterday. Here is just one graph that displays the magnitude of their proprietary trading of indescribably complex financial products. Do remember that you need to add 6 zeroes to the numbers along the y-axis.

With much more detail, the FDIC/SEC/Treasury/Federal Reserve also tried to explain proprietary trading. They needed 298 pages, 1300 questions and 400 topics.

Responding, former banker Henry Kaufman took a different path.

“Paul Volcker and I are the same age [84]. Paul wanted to take an aspect of risk-taking out of the financial conglomerates. That’s a worthy endeavor. But the history of regulation shows that the private sector pushes back and waters it down. Dodd-Frank didn’t want to address the longer-term consequences of ‘too big to fail.’ The 10 largest banks held 10 percent of the assets in 1990; today they control over 70 percent. This trend accelerated in 2008. The ‘too big to fail’ got even bigger.”

He continued, “My view is that we should break up the big financial conglomerates and separate investment banking. Otherwise we’re going to have ongoing government intervention in the credit allocation process. That threatens economic democracy, and the U.S. is the last bastion of economic democracy.”

Sounds like Glass Steagall.

A 34 page 1933 law, Glass-Steagall separated investment and commercial banking, changed the structure of the Federal Reserve and created the FDIC. J.P. Morgan knew, for example, that it had to divide itself into a commercial bank and an investment bank. 2 entirely separately owned firms, Morgan Guaranty, a commercial bank and Morgan Stanley, an investment bank were the result.

And now, we are back to where we started.

Sources and Resources: For primary sources, here is a lengthy description of the Volcker Rule while here is the 34 page Glass Steagall Act. For interpretation, this 2011 NY Times column discusses the Volcker Rule’s implications and the Henry Kaufman response. Finally, to see more about yesterday’s testimony, here is the Committee document and here is a WSJ article (the source of the above graph).

Posted by: adminEcon
Tags: "too big to fail", Dodd-Frank, Glass-Steagall, Volcker Rule
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08.15.2011 | Too Big To Fail

Imagine for a moment that you are the CEO of a large bank. Offered the opportunity to participate in a risky business deal, you say, “Yes.” If the venture succeeds, you benefit. If it fails and threatens your bank’s survival, the government is there to experience the loss because your bank is “too big to fail.”

In a 2009 econtalk podcast, Gary Stern, past head of the Minneapolis Fed said that “too big to fail” distorts markets. Explaining why, he said that once creditors expect that an institution will be rescued, no matter how risky its behavior, its demand curve shifts lower than it should be for that institution’s securities. The result is “mispricing.” With borrowing less expensive, bankers have the incentive to engage in the risky behavior that creates systemic calamity.

Agreeing, Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City said, “…Without this market discipline provided by creditors willing to withdraw their funds when they suspect a bank of being unsafe, banks have an incentive to take excessive risks.” To people who say Dodd-Frank provides a solution, Dr. Hoenig disagrees. Instead, he believes that the only answer is breaking up large institutions.

Here, in a previous post, more is discussed about the problems of breaking up large banks.

The Economic Lesson
Whenever banking is discussed, someone always refers to Glass-Steagall as a benchmark. Passed in 1933, Glass-Steagall is primarily associated with creating the FDIC and requiring banks to spin off their investment banking activities as separate firms. Repealed in 1999, actually, Glass-Steagall had gradually been unraveling since 1980.

An Economic Question: Economist Sam Peltzman once suggested that a solution to a problem sometimes creates the results you are trying to prevent. For example, seatbelts might lead to more accidents because drivers become careless. Might “too big to fail” be an example of the Peltzman Effect?

Posted by: adminEcon
Tags: "too big to fail", Dodd-Frank, Federal Reserve, Glass-Steagall, risk, Thomas M. Hoenig
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05.25.2011 | Too Big To Fail

The HBO documentary, “Too Big To Fail” was excellent. But what to come away with?

TBTF (Too Big To Fail) solves problems and it creates them.

TBTF can reverse a confidence crisis. When the world is worried that the failure of a large bank will catastrophically ripple from one institution to the next until all financial markets are frozen, TBTF can solve the problem.

However, TBTF distorts financial behavior. Without TBTF, for chancy loans and risky projects, creditors provide less funding and ask for higher returns. With TBTF, by diminishing risk, the creditors’ incentives change. Consequently, it is much easier to fund speculative ventures that might endanger the institution.

In other words, TBIF creates the very problem that it solves!

Here, during an Econtalk interview, economists discuss TBTF. Also, the book, Too Big To Fail, by a former Federal Reserve president and vice president provides considerable insight. A third resource is the book on which the HBO documentary was based, Andrew Ross Sorkin’s Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System–and Themselves.

The Economic Lesson

In 1781, Alexander Hamilton said that, “Banks…have proved to be the happiest engines that ever were invented for advancing trade.” In 1791, primarily because of Alexander Hamilton, the first Secretary of the Treasury, the First Bank of the United States was established by the U.S. Congress.

With only 3 banks in the entire country, Hamilton believed more could be done to expedite U.S. economic development. His goal was to have more money circulating that businesses, consumers, and government could use. As a powerful and large financial intermediary, the bank achieved his objectives.

An Economic Question: Looking at 1791 and 2011, explain why borrowing is important for economic activity.

Posted by: adminEcon
Tags: "too big to fail", Alexander Hamilton, Andrew Ross Sorkin, bailout, financial intermediaries, First Bank of the United States, moral hazard, risk
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03.10.2010 | The Top 19

Are 19 banks “too big to fail?” Listening to Bloomberg radio, I heard that four banking firms control close to 50 percent of their industry’s assets, that the top 19 control 85 percent, and that the bottom 8000 control 15 per cent. An FDIC report from 2006 described a similar trend.

In a recent econtalk podcast, Gary Stern, past head of the Minneapolis Fed said that “too big to fail” distorts markets. Explaining why, he said that once creditors expect that an institution will be rescued, no matter how risky its behavior, its demand curve shifts lower than it should be for that institution’s securities. The result is “mispricing”. With borrowing less expensive, risky behavior is fueled with funds. Place that fund supply on steroids as before the 2007 panic and you have the potential for a “systemic” calamity. And, going full circle, if systemic calamity is possible, than those big enough to cause it, cannot fail. The challenge is to stop that cycle.

Is the solution smaller financial institutions? As happened during the late 1970s, when banks were prohibited from competing and growing freely, other financial firms took away the banks’ business with a better deal–a higher return and new financial products– for their customers. As a result, the attempt to preserve healthy institutions wound up threatening their survival. Today, we have an international financial community ready to offer “better deals” if we limit our banks. And, we also have an industry where new products, that regulators never imagined, surface daily. Is the solution new regulations? Enforce existing regulations better? Permit failure and let the market take care of itself? Your comments?

The Economic Lesson

Whenever banking is discussed, someone always refers to Glass-Steagall as a benchmark. Passed in 1933, Glass-Steagall is primarily associated with creating the FDIC and requiring banks to spin off their investment banking activities as separate firms. Repealed in 1999, actually, Glass-Steagall had gradually been unraveling since 1980.

Posted by: adminEcon
Tags: "too big to fail", banking regulation, Glass-Steagall
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