Too-Big-to-Fail Banking Has Got-to-Go

The protestant reformation began in October 1517. That was when Martin Luther nailed his 95 theses to the door of a church in Wittenberg, Germany. Among other things, Martin Luther was protesting the sale of “indulgences” by the Roman Catholic Church.  Pay enough and ones’ sins would be forgiven.

A similar— but entirely economic and secular— protest may have occurred with the publication of the annual report of the Federal Reserve Bank of Dallas. The report calls for the end of Too-Big-To-Fail and the breakup of our largest banks. TBTF has led the big banks and those who run them to receive gigantic indulgences (not to mention economic salvation) at taxpayer expense.

Richard Fisher, the bank’s President, has given speeches about the TBTF problem since 2009. But in this report he states the problem and his position very clearly, right under his picture:

 “The too-big-to-fail institutions that amplified and prolonged the recent financial crisis remain a hindrance to full economic recovery and to the very ideal of American capitalism. It is imperative that we end TBTF.”

No waffling or wimp talk there.

The 20 page essay that follows, “Choosing the Road to Prosperity: Why We Must End Too Big to Fail Now,” written by Senior Economist Harvey Rosenblum, lays out how the asset concentration in the top 5 banks has tripled from 17 percent in 1970 to 52 percent in 2010; the weakness of recovering and undercapitalized banks; why that has resulted in a weak economic recovery; and the likely failure of the Dodd-Frank legislation to end TBTF.

In one small text box, “TBTF: A Perversion of Capitalism,” Rosenblum summarizes the moral hazards and public damage caused by having institutions that are deemed too big to fail.

 “An unfortunate side effect of the government’s massive aid to TBTF banks has been an erosion of faith in American capitalism. Ordinary workers and consumers who might usually thank capitalism for their higher living standards have seen a perverse side of the system, where they see that normal rules of markets don’t apply to the rich, powerful and well connected.

 “Here are some ways TBTF has violated basic tenets of a capitalist system:

  • “Capitalism requires the freedom to succeed and the freedom to fail. Hard work and good decisions should be rewarded. Perhaps more important, bad decisions should lead to failure— openly and publicly. Economist Allan Meltzer put it this way: ‘Capitalism without failure is like religion without sin.’
  • “Capitalism requires government to enforce the rule of law. This requires maintaining a level playing field. The privatization of profits and socialization of losses is completely unacceptable. TBTF undermines equal treatment, reinforcing the perception of a system tilted in favor of the rich and powerful.
  • “Capitalism requires businesses and individuals be held accountable for the consequences of their actions. Accountability is a key ingredient for maintaining public faith in the economic system. The perception—and the reality— is that virtually nobody has been punished or held accountable for their roles in the financial crisis.”

The left and the right of American politics don’t agree on much but there is one thing the Tea Party and Occupy Wall Street (not to mention the voting public) would joyously agree on—  Too Big To Fail has got to go. The idea of breaking up the big banks is adored by everyone but the bankers and the more conventional politicians the bankers so generously fund.

Are there alternatives to breaking up the big banks? Two come to mind.

One is for the boards of directors of the big banks to establish big time claw-backs on executive compensation so the top dogs can lose it all if they take excessive risks. Grant’s Interest Rate Observer editor, James Grant, advocated this idea in a recent speech at the New York Federal Reserve Bank.

Another is to adopt “limited purpose banking” in which banks are paid fees to connect borrowers and enterprises with lenders and investors, without taking risk. This is very much like what mutual fund firms do. Limited purpose banking would end the privatization of profit and the socialization of loss. This idea is advocated in “The Clash of Generations,” a new book I co-authored with economist Laurence J. Kotlikoff.