Too Big To Fail - But They Did, and They Could Again

More and more voices are joining the chorus: There are still too many Too Big To Fail banks out there, and we're all on the hook.

They're Too Big To Fail, Too Big To Control, and Too Big To Be Safe For The Economy.

Am I parroting the calls from Occupy Wall Street? Well, yes.

But I'm also parroting ... the Federal Reserve Bank of Dallas, widely considered one of the most conservative of the regional banks.

As reported by Robert Reich in Salon (essay, here) and Jesse Eisinger of ProPublica (via the New York Times' DealBook; article, here), the 2011 annual report's lead essay notes that

For all its bluster, Dodd–Frank leaves TBTF [Too Big To Fail] entrenched. The overall strategy for dealing with problems in the financial industry involves counting on regulators to reduce and manage the risk. But huge institutions still dominate the industry—just as they did in 2008. In fact, the financial crisis increased concentration because some TBTF institutions acquired the assets of other troubled TBTF institutions.

These banks have emerged from the crisis with "the lawyers and the money to resist the pressures of federal regulation."

The problem is not just one of economic risk to the nation as a whole. There's a concerning psychological effect as well:

The rationale for providing public funds to TBTF banks was preserving the financial system and staving off an even worse recession. The episode had its downside because most Americans came away from the financial crisis believing that economic policy favors the big and well-connected. They saw a topsy-turvy world that rewarded many of the largest financial institutions, banks and nonbanks alike, that lost risky bets and drove the economy into a ditch.

These events left a residue of distrust for the government, the banking system, the Fed and capitalism itself. These psychological side effects of TBTF can’t be measured, but they’re too important to ignore because they affect economic behavior. People disillusioned with capitalism aren’t as eager to engage in productive activities. They’re likely to approach economic decisions with suspicion and cynicism, shying away from the risk taking that drives entrepreneurial capitalism. The ebbing of faith has added friction to an economy trying to regain cruising speed.

The entire Dallas Fed report, "Choosing the Road to Prosperity: Why We Must End 'Too Big To Fail' -- Now" is available here (launches as PDF).

What does the essay's author (Dallas Fed EVP and director of research Harvey Rosenblum) recommend?

The only viable solution to TBTF lies in reducing concentration in the banking system, thus increasing competition and transparency.

In other words, break up the biggest banks into smaller units.

Not surprisingly, this proposal was not met with resounding cheers on Wall Street. Reich quotes "one of the Street's major defenders in the Capitol" as saying, "Dallas doesn't know its [backside] from a prairie gopher hole." [Reich's euphemism]

Now there's an intelligent, considered response.

In fact, as both Reich and Eisinger point out, it may be that no one understands TBTF better than Dallas -- the savings-and-loan crisis of the '80s and early '90s struck Texas particularly hard with its own TBTF institutions, that, indeed, ended up failing.

The key problem is that while we may wish for / demand / regulate less risky behavior on the part of these institutions, as long as there is no true downside risk (because government will again be forced to step in to bail them out), more risky behavior is bound to occur.

Thank you, Mr. Rosenblum. Now: Are you listening, Mr. Bernanke?