Firms like that the government still thinks they're 'too big to fail.'
Texas Rep. Jeb Hensarling wants to give the nation's largest banks a choice: they can follow President Barack Obama's Dodd-Frank financial-reform law, passed six years ago, or they can raise hundreds of billions of dollars' worth of insurance money against future losses. This idea is unlikely to become law. But even if it did, big banks would be unlikely to take advantage of the new freedom, because Dodd-Frank is far more complex, and they prefer complexity, not simplicity. Complexity makes it harder for the government to let them fail, as the government is afraid of the consequences.
“Washington is effectively saying to investors in these firms: "Don't worry, we're looking out for you." This message is not a good one for a free-market economy to send.”
Obama signed Dodd-Frank two years after Lehman Brothers' collapse caused global economic chaos and the government had to step in and rescue big banks, including Citigroup and Bank of America, to prevent more pain. The idea was to create a way for large firms to fail without taking down the rest of the economy, to make sure taxpayers would never have to stand behind financial firms again.
But Dodd-Frank was more complicated than necessary to fix "too big to fail," and its complexities contain fatal contradictions.
To wit: the law created a new government council that determines which large banks "could pose a threat to the financial stability of the United States" if they go bankrupt, or even exhibit "distress." The government is supposed to keep an eye on those banks to make sure they don't fail, but it's also supposed to make sure that these banks have plans in place to protect the economy if they do fail.
This philosophy sends mixed signals. Big banks are supposed to compete like any other businesses, and if they make bad decisions that put them out of business, so be it.
Yet the government now says explicitly that it's not a good idea for any of these three dozen select banks – plus a few other financial firms – to go out of business. Washington is effectively saying to investors in these firms: "Don't worry, we're looking out for you."
This message is not a good one for a free-market economy to send. No private company should have protection from bankruptcy. American Airlines, our country's biggest air carrier, has gone bankrupt, as have big supermarket chains such as the A&P. Protecting particular companies in particular industries gives them an unfair advantage.
Worse, the government hasn't been able to prod these special-ward banks into putting together credible bankruptcy plans. In April, regulators rejected five huge banks' hypothetical scenarios of how they would put themselves out of business.
What would be better? Hensarling, chairman of the House Financial Services Committee, told a New York audience last week that his forthcoming bill would force banks to hold more capital – that is, a bigger cushion of non-borrowed money for every dollar they risk in lending and investment. (This is no different than people's everyday lives; the less debt you have, the better off you are in a crisis such as a job loss.)
Banks are holding more non-borrowed capital since 2008. Regulators are using authority they already had before Dodd-Frank to require firms to put more money in reserve. But, Hensarling said last week, "capital standards that were already complex have become even more complex and controlling. I do not believe this to be a good thing." Banks are allowed to set their own capital standards based on how risky they think their own assets are.
Hensarling's solution is simple: ask banks to maintain 10 percent of their assets in capital – up from 3 percent under global standards, and 6 percent under new rules regulators have been implementing.
Banks that raised the hundreds of billions in extra cash this would require would be exempt from much of Dodd-Frank, because the investors putting up this capital, not taxpayers, would bear the risk of failure.
Yet banks have hardly reacted to Hensarling's plan with enthusiasm. Why? Hensarling noted that the Dodd-Frank system "confers a competitive advantage on those large financial institutions that have the resources to navigate its mind-numbing complexity."
In other words, the government cannot quite keep up with the banks as the banks create their own risk models to say how they have minimized their risk – and the banks and their investors like it that the federal government still worries that they're still too big to fail. When investors see that a bank has failed its government test of whether it can go bankrupt or not, they smile. Making it truly simple for firms to go under would cause investors to think it might actually happen.
This piece originally appeared in U.S. New & World Report
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Nicole Gelinas is a senior fellow at the Manhattan Institute and contributing editor at City Journal. Follow her on Twitter here.
This piece originally appeared in U.S. News and World Report