National Conference of Bankruptcy Judges--10/14/11--Too Big to Fail

Dr. Thomas Hoenig was the Friday luncheon speaker. He served for twenty-five years as President and CEO of the Federal Reserve Bank of Kansas City. He said that he “wanted to get you on board that Too Big to Fail is bad policy.” He warned that the crisis brought about by Too Big to Fail in 2008 was likely to recur. He said that “unless you acknowledge the problems that brought about the crisis, it would happen again. He identified some of the factors as distorted incentives, not allowing the market to function and subsidizing favored groups.

Dr. Hoenig identified three pieces of legislation as creating the climate for Too Big to Fail. The Glass-Steagall Act extended protections to commercial banks in the form of deposit insurance in return for separating out their risk-based activities. He described Glass-Steagall as “a covenant between government and the private sector” to “extend protection around you because of your role in society.” He said that “in return for special protection, we will limit (the activities of commercial banks) to payment systems and financial intermediation systems because these are the purposes we want to protect.” He said that if commercial banks wanted to engage in risk-based activities, they would have to do so with their own capital in a separately chartered entity. He said that Glass-Steagall was the system in place until the 1980s and “worked reasonably well.”

According to Hoenig, “with stability comes its own sources of weaknesses.” The demand to take down the wall between commercial banking and other activities led to the Gramm-Leach-Bliley Act of 1979. The effect of GLB was to allow banks to invest in risk with a federal backstop. The risk of this was predicted by Adam Smith who noted that merchants would seek to widen the market and narrow their competition. While widening the market is desirable, narrowing competition is not. GLB narrowed competition by allowing some players an artificial subsidy. By eliminating Glass-Steagall, the market share of the largest banks was increased from 14% in 1979 to 60% in 2007. “Thus was born too big to fail.”

The Dodd-Frank legislation was supposed to fix Too Big to Fail. He said, “I am concerned that it won’t” because “the incentives haven’t changed.” The largest institutions are now 20-30% bigger and the cost of capital is being kept artificially low. Under Dodd-Frank, if a TBTF institution finds itself on the ropes, the regulators must make a decision about whether the institution is solvent but illiquid or insolvent. This decision must be made on a Friday afternoon and must be approved by the Secretary of the Treasury and the Chairman of the Federal Reserve with possible involvement by the courts. He asked, “Who can take an institution of $2.2 trillion into receivership over the weekend?” As a result, he predicted that regulators would be inclined to find that the entity was solvent but illiquid and inject federal dollars to keep it afloat. As a result, he said, “the market doesn’t function” and “there is no cleansing of the market.”

Dr. Hoenig said that anything this large cannot be allowed to fail. As a result, the incentives must be changed. He noted that in the current system, profits are privatized and losses are socialized. He recommended that investment banking, trading and other risk-based activities be moved into separate entities with private capital. He also called for making the competitive market more fair. He said that regional banks cannot compete with the twenty largest entities because they are not subsidized.

Dr. Hoenig said that he disagreed with those who said that current capital requirements for commercial banks are too stiff. He disagreed, noting that before there was a federal safety net, financial institutions maintained capital of 15-20% compared to the current 7%. He said that (15-20% capital) is “what the market called for.”

He also disagreed with those who said that such measures would place U.S. financial institutions at a competitive disadvantage compared to institutions in other parts of the world. Dr. Hoenig said that foreign banks were not a good model to follow. He said “look at their banks.” He said, we are “not in a competitive process to excellence, but a competitive process to the bottom.”

He also warned that the country was too leveraged. He said that consumer debt as a percentage of GDP had grown from 80-90% to a high of 125% before dropping to the current level of 114%. At the same time the savings rate fell from 8% to 0% although it has risen back to 5%.

Dr. Hoenig described the federal government as being in crisis. He said that government debt had increased from 40% of GDP in 1990 to 100%. Currently interest rates average 2.5%. He asked what if market interest rates began to apply? He said that monetary policy has been captured by Too Big to Fail.

(I apologize in advance if I incorrectly transcribed any of Dr. Hoenig’s statistics or their units of measurement. I was taking notes as quickly as I could but possibly not quickly enough. Any statements that do not make sense are the result of my reporting rather than the content of the speaker).