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The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics.

Why We Need to End Too Big To Fail (Part 3) - too big to fail

Source: David Shankbone 

In two previous essays, here and here, I argued that the only way to end too big to fail (TBTF) is by constitutional amendment. In this essay, I am going to present my case for why we need to end TBTF.

One of the reasons is completely “American,” it will make all firms self-reliant. All firms will have the incentive to take care of themselves when they know they can’t be bailed out. Financial institutions will use well-known and understood risk management techniques to limit their risks. They will undertake due diligence to know to whom they are lending or dealing with in order to guard against the two principal risks in doing business, adverse selection and moral hazard (for those not familiar with these terms, see the explanation at the end of this essay).

Too Big To Fail Is Unnecessary: Here are the Facts

My second reason, based on economics and the experience of the recent financial crisis, is more compelling: TBTF is unnecessary! I can hear some readers say, but Ben Bernanke and other economists, policymakers, and government officials said that the actions taken by the Federal Reserve, the Treasury, and Congress saved us from a second Great Depression. Yes, I know what they said, but that doesn’t mean it’s true. Such comments stem from a belief, not from facts. The belief is that the failure of a large, systemically important firm will bring down the entire system and cause a large and protracted recession, if not, depression.

Here are the facts based on the experience of the financial crisis: The financial crisis began on August 9, 2007, when the French bank and financial services company, BNP Paribus, suspended the redemption of three of its investment funds. Prior to Lehman Bros.’ bankruptcy announcement on September 15, 2008, the Federal Reserve lent to banks, mostly through the Term Auction Facility (for a description, see TAF). Such lending would normally increase the total supply of credit in the market, but the Fed sterilized it. Specifically, the Fed sold an equal amount of government securities to prevent the total supply of credit from increasing. “Why?”

The Fed did this in order to be able to continue to implement monetary policy by adjusting its target for its policy rate—the federal funds rate. The Fed reduced the target from 5.25% at the start of the financial crisis to 2% on May 4, 2008.

The Fed took other actions too. It invoked section 13(3) of the Federal Reserve Act in March 2008 that permits the Fed to lend to anyone “in unusual and exigent circumstances” in order to bailout the New York-based global investment bank Bear Stearns. It also used section 13(3) to introduce new lending programs, such as the Primary Dealers Credit Facility (for a description, see PDCF), to alleviate the financial crisis. TBTF indemnifies large firms who have a significant informational advantage over smaller firms and individuals and, hence, are less likely to be victims of moral hazard and adverse selection, while providing no protection to those who are significantly more susceptible to these risks.

“Did this work?” No!

Why We Need to End Too Big To Fail (Part 3) - callout

The financial crisis intensified and the economy continued to spiral down. The recession, which began in December 2007, intensified. Essentially, everything got worse; nothing got better. The worsening financial crisis culminated with the bankruptcy of Lehman Bros. on September 15, 2008—the largest bankruptcy filing in U.S. history.

“What happened after Lehman’s bankruptcy announcement?”

Things got much worse—but not for long. The recession, which had been getting progressively worse, ended just 9 months later in June 2009. The financial crisis, which began on August 9, 2007, was showing marked signs of recovery by early 2009. Specifically, credit risk spreads, which exploded immediately following Lehman’s announcement, had declined significantly by late February 2009 and by June, or slightly later, most were near or below their pre-financial-crisis level (see The Fed’s Response to the Financial Crisis: What It Did and What It Should Have Done for the details).

This is so remarkable that it deserves repeating: The financial crisis and the recession, which had worsened 13 months and 10 months, respectively, from August 2007 were over 9 months after the worst financial event since the October 1929 stock market crash.

I believe this is extraordinary. “What was different?” The Fed’s monetary policy. Prior to Lehman, the Fed sterilized its lending so the total supply of credit didn’t increase. After Lehman, the Fed didn’t sterilize its massive lending so the total supply of credit increased. “How much?” From Lehman’s announcement to mid-January 2009, about $900 billion.

Just as economic theory suggests, markets can heal themselves if provided with the appropriate assistance: Appropriate monetary policy was sufficient to deal with the economic consequences of the financial crisis; there was no need to bail out large financial institutions.

Unfortunately, the Fed didn’t increase the total supply of credit following Lehman’s announcement because it realized that it was the best policy for dealing with financial crises. It did it because it no longer had the resources to sterilize the lending (see Requiem for QE, pp. 5-6). Indeed, the Fed wasn’t even aware of the positive effects its unsterilized lending was having on financial markets and the economy. That this is so, is dramatically illustrated by future Chair Janet Yellen’s comment just three months prior to the recession’s end (at the March 18, 2009, Federal Open Market Committee, FOMC, meeting), “I think we’re in the midst of a very severe recession—it’s unlikely to end soon.” Oops!

The Fed did the right thing in spite of itself.

But, unfortunately, was blind to the effectiveness of its inadvertent actions. “Why didn’t the policymakers see this?” Good question. I think there are a number of reasons, not the least of which is they didn’t consider increasing the total supply of credit as a policy action. They were myopically focused on the federal funds rate. To policymakers, monetary policy wasn’t increasing the supply of credit to the market; monetary policy was reducing interest rates. The Federal funds rate went to zero with the massive increase in unsterilized lending (the details can be found here), in spite of the fact that the FOMC didn’t reduce the target to effectively zero until December 15, 2008 (see Requiem for QE, pp. 5-6).

The FOMC was also driven by the misguided belief that the economic expansion should be accompanied by output growth in the range of 3% to 4%—policymaker’s estimate of potential output growth. They were blind to the facts that:

  1. Output growth had been trending down significantly over the last 60 years and was by the recession’s end in the neighborhood of 2% to 2.5%, and
  2. That the output growth experienced from about 1995 to 2007 was an anomaly, driven by an unexpected increase in productivity, a technology boom, and other factors.

(For more details, see Larry Summers Is Wrong About Growth and Economic Growth: Part 1).

I will end this essay with two additional comments.

First, I want to point out something that I failed to make in my previous essays. Specifically, I want to note that while making large banks hold a large amount of capital, as Neel Kashkari and others suggest, will likely eliminate the need to bailout large banks during a financial crisis, it is a very costly option.

In presenting his Bank’s solution to end TBTF at the National Association of Business Economists Annual Policy Conference, President Kashkari said that when he got a mortgage recently, the bank required that he put 20% as a down payment. Hence, he saw no reason that the banks should not have to do the same. The attendees reacted favorably to this comment. After thinking about this a while, I realized this was unfortunate because most of the attendees were economists. Economics clearly shows that these two things—a 20% down payment requirement and making large banks hold capital of 20%+ —are not comparable.

“Why not?” The reason is that an individual cannot pass the cost of the down payment requirement to someone else. In contrast, most or all of the increased costs of the 20%+ capital requirement will be passed on to the public in the form of higher costs. Financial crises have been and hopefully, will continue to be rare events. Hence, the cumulative costs of this “fix” could be substantial.

Moreover, as I noted previously, it does nothing to prevent the failure of non-bank financial institutions or other firms. Hence, it makes no sense to incur these costs because:

  1. TBTF can be eliminated with a constitutional amendment,
  2. Appropriate monetary policy and the markets’ self-correcting mechanisms are sufficient to deal with financial crises,
  3. Eliminating TBTF and appropriate oversight should reduce the likelihood of financial crises, and
  4. TBTF indemnifies large firms who have a significant informational advantage over smaller firms and individuals and, hence, are less likely to be victims of moral hazard and adverse selection, while providing no protection to those who are significantly more susceptible to these risks.

My second comment is that TBTF is a mindset that stems from fear—fear of the unknown. Specifically, fear that the failure of a large, systemically important firm will produce a domino effect that will unleash the next Great Depression. Of course, there is no specific evidence that it will, or even that it should. Indeed, no one can say exactly what constitutes a “systemically important firm.”

Nevertheless, most are fearful of what will happen if one fails. But fear often leads to bigger problems than the one of which we are so fearful. Recall that the domino theory of communism was a principal reason for the U.S. involvement in Vietnam and, ultimately, the Vietnam War.

As was the case with communism, fear of the failure of a systemically important firm is blown out of proportion. As is too often the case, fear causes TBTF which significantly increases the likelihood that a large firm—especially, a large financial firm—will fail and, therefore, increase the likelihood of a financial crisis and recession.

Adverse Selection and Moral Hazard in Lending

Adverse selection arises because of what economists call asymmetric information. Specifically, the borrower typically has more and better information than the lender. Adverse selection is the proposition that the people most desiring a loan are the least likely to repay it. Your uncle Ned is a ne’er-do-well spendthrift. He is always trying to borrow money from someone. You know it and so does everyone in the family. Consequently, no family member will make poor Ned a loan. As far as the banker is concerned, Ned is just another person who works for a living coming into the bank to borrow money.

Of course, bankers and other lenders try to protect themselves from the Uncle Neds of the world by doing credit histories and checks, requiring down payments and in some cases collateral, but a few Uncle Neds are bound to slip through.

The second way that asymmetric information makes lending risky is because of moral hazard. Moral hazard comes into to play after the loan is made. Once the loan is made, the borrower may have an incentive to act in a way that is not in the best interest of the lender. That is, borrowers’ and lenders’ interest are not likely to be incentive compatible.

For example, suppose your cousin has an idea for a business venture that sounds good. He has no capital to get the business going, so you make him a loan. Once your cousin gets the business going, circumstances change. He now believes that if this business is ever going to make a profit, he will have to take some additional risks that will jeopardize the capital. Since it is your capital that is at risk, he has everything to gain and little to lose. Consequently, your cousin may engage in risky activities that you would not have agreed to at the time you lent him the money.

One way to make lenders and borrowers more incentive compatible is to require the borrower to put some of his own capital at risk. Your cousin’s interests and yours would be more compatible if your cousin had something to lose, too. The more he has to lose, the more careful he would be.

Thus, it is not surprising that lenders frequently require a down payment—not borrowed from another source—when they make a loan. But this too requires information. How do you know that the borrower’s capital was not borrowed from someone else? How do you know that this capital is not pledged as collateral for another loan?

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.