Too Big to Fail, Too Big to Save
By W. Bernard Mason

Last week the U.S. Congressional Joint Economic Committee held an important hearing that explored the government's actions in dealing with the current financial crisis. This hearing, held on April 21, 2009, looked at the concept of "too big to fail" and the use of public funds to bolster the operations of the nation's "systemically important" financial firms. Appearing before the committee were economists Joseph Stiglitz and Simon Johnson, and Kansas City Federal Reserve President Thomas Hoenig.

Congresswoman Carolyn Maloney (D-NY), current committee chair, began the session by asking the witnesses whether they believed the federal government was applying a double standard in attempting to resolve weaknesses in individual financial firms. The three witnesses agreed that smaller banks continue to be closed and resolved in the traditional manner; however, they viewed the government as unwilling to come to grips with the problems presented by larger firms. Dr. Stiglitz stated his view that the disadvantages outweigh the advantages in this approach. In his view, smaller community banks provide the basic services to our economy, but the government is devoting most of the resources to the bigger banks that do not add value to the economy. He believes the presumption should be that these larger firms should be broken up. Both he and Dr. Johnson dismiss the argument that eliminating these banks will make the U.S. less able to compete on a global scale. Dr. Johnson expressed the view that Europe will be slower to recover from this recession because European banks are so large relative to their overall economies.

Dr. Johnson said the real risk-takers and entrepreneurs in this country are enraged by the incompetence and hubris of big bank management in the U.S. He believes we should return to the earlier model of investment banks operating with their own equity (generally partnership equity), not "widows' and grandmothers'" deposits and 401K accounts. Venture capitalists and long-term bondholders should be the primary risk-takers. He feels financial services providers should be operated like public utilities (make banking boring), with little risk-taking. Dr. Hoenig emphasized his view that the U.S. clearly operates with a dual standard and the large bank business model has not given us a competitive advantage globally.

In response to a question from Sen. Brownback (R-KS), Dr. Hoenig stated his view that if any of the nation's four largest banks were to falter, the government should step in, take a senior position, eliminate the stockholders, and replace management. For the good of the economy, he believes these large banks should be treated just like any other bank - if losses exist, they must be recognized and taken. He said we have a proven roadmap in the way the FDIC handled the Continental Illinois failure in the 1980s. Dr. Johnson cited the Japan model as the example we do not want to emulate. Dr. Stiglitz stated that far from doing damage to the economy, closing weak banks and recognizing the losses is the surest way out of the current situation.

Dr. Stiglitz offered the view that the current crisis was providing us the opportunity to take needed steps to strengthen the banking system. By utilizing the Continental Illinois model, we could re-focus a bank's mission, using public money to provide valuable banking services. He stated that the current crisis had revealed a significant weakness in big bank corporate governance, evidenced by the lavish compensation arrangements accorded senior management while bank stockholders were suffering massive market losses due to management missteps.

Regarding TARP, Dr. Stiglitz stated that the original decision-makers had operated under the mistaken view that merely announcing the program would restore confidence and actually expending funds would have been unnecessary. Instead of doing this, big banks should have been put into conservatorship and restructured. He says this may have required some public funding (impossible to say now), but the major funding burden would have been placed on equity and bondholders who are supposed to have money at risk. Public funding would have been much less, and the government's balance sheet would ultimately be stronger.

Dr. Stiglitz further stated that we are now institutionalizing a bad practice by continuing to place TARP funds in institutions. He believes we are losing more money and are missing the opportunity to restructure. He believes we should halt further TARP activity until government officials can determine goals and objectives for this program. He says we are worse off than the United Kingdom, because at least U.K. officials demanded more management control in return for the government's bank investments - we don't even want to know where the money is going. We have been separating ownership and control. The government is putting in money, but not ensuring that the bank operates properly. As owners, he said we should be insisting on the highest levels of corporate governance (we should not be operating as slumlords or exploiting customers through excessive credit card fees). Dr. Hoenig concurred that we have missed an opportunity to properly decide about allocating public funds to achieve the kind of banking system we want and need. He said that, while decision-makers were under pressure to do something, spending such large sums should have required an organized plan (tailored from the lessons of the Continental Illinois case).

With regard to credit card fees, Dr. Stiglitz said that the recent actions by card issuers clearly evidence a lack of competition in this industry. He believes concentration in this area is particularly severe, and the card companies seem amazingly insensitive to the political risks of such activities in this environment. Dr. Johnson said these activities provide clear evidence of collusion and should be referred to the Department of Justice for investigation. Beyond this, he said we are allowing large banks to use TARP funds to take short positions in the securities of other banks- -exacerbating the current problem and potentially leading to further taxpayer losses. He said it was inconceivable that the government would not seek to impose controls on the use of taxpayer funds.

Dr. Johnson said we should have had a conservatorship program in place, and it should have been used to address the Bear Stearns case. He said U.S. officials had wrongly perceived the problem as a liquidity issue, even though G-10 officials had been warning us for two years that we were facing a solvency issue. Solvency is addressed through conservatorship and re-structuring. He says the solvency problem still exists, particularly among the larger banks, and TARP has failed to address this.

On systemic regulation, Dr. Stiglitz said we should have a regulatory regime that looks at all firms and all operational aspects (compensation programs, leverage, etc.). He believes it would be difficult to operate with a given list of systemically important firms because, in a dynamic economy, an ordinary entity can become systemically significant overnight (he said the systemic risks posed by AIG came about only after its obscure Financial Products division's ill-fated transactions were booked). In his view, the Federal Reserve did not do such a good job in the run-up to this crisis—it failed to use the regulatory powers it possessed—and he would not be in favor of bestowing "systemic regulator" authority on the Fed. Instead, He believes there should be a consortium of regulatory bodies, including a Financial Products Safety Commission and a federal insurance regulator, looking at the system as a whole. He said transparency and disclosure is important, but not enough. Regulation must be comprehensive. In partial defense of the Fed, Dr. Hoenig stated that no one did a good job, because de-regulation was the watchword. We allowed ourselves to think that sophisticated approaches were good substitutes for fundamental principles. Dr. Johnson added that regulators get captured by innovations such as derivatives, or new approaches to mortgage lending, and lose sight of the basics. Dr. Johnson says we need a "big" regulator, but the real key is breaking up the big banks. Having just a few "titans of finance" is asking for trouble.

Dr. Stiglitz said that, unlike some smaller countries where politicians wield undue influence over their banking systems, in the U.S. the large banks have managed to control the political process. They have tried to put forth the view that there is no alternative other than throwing money at the problem without utilizing the conservatorship process. He stated the conservatorship model is actually less risky, since it has been used in past cases, both here and abroad.

Regarding the Public-Private Investment Program (PPIP), Dr. Stiglitz re-stated his previous public position that the plan is very badly designed. He said the program is tilted against the taxpayer, since the government will put up the bulk of the money, but receive less of the return. He said the program has built-in incentives to delay resolution of these assets. Dr. Johnson flatly stated that PPIP will not work. He is convinced banks will not participate due to the government's involvement in compensation programs, and hedge funds don't want potential government intrusion into their operations. Dr. Hoenig said he has talked with parties on both sides, and both sides have concerns. For banks, the program assumes losses have already been recognized; for investors, they know if they reap healthy rewards, they will incur public criticism.

Regarding the current stress test exercise, Dr. Johnson said he believes the government's worst case assumptions are mild ones and very little will be learned regarding the true soundness of these banks. He repeated the often-stated government dilemma - -the stress tests must show some banks to be weak in order to validate the tests, but revealing the existence of weak banks may create further market problems.

Following concluding remarks from the panelists, the hearing was adjourned.

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W. Bernard Mason is the Regulatory Relations Liaison for The Risk Management Association. He may be contacted at bmason@rmahq.org.