Progress on 'Too big to fail'?

By Mark Edelman and Barry Flinchbaugh

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ME.  Recently, Thomas Hoenig, Vice Chairman of the Federal Deposit Insurance Corporation (FDIC) came to Iowa State University to present a lecture in the College of Business.  As you may recall, Hoenig was President of the Kansas City Federal Reserve Bank from 1991 to 2011.  As it turns out, he is originally from Fort Madison, Iowa and received a Ph.D. in economics from Iowa State University.

 BF.  I served on a local bank board for 28 years and I am familiar with Hoenig.  He was with the Federal Reserve for 38 years, beginning as an economist and then as a senior officer in banking supervision during the 1980s banking and farm finance crisis.  During the 1980s, Hoenig directed oversight for more than 1,000 banks and holding companies with assets ranging from less than $100 million to $20 billion.  He demonstrated that he is a very capable, tough character.  He did not march to the drumbeat in the Greenspan era and stood firm on his point of view, becoming somewhat controversial.  So what has he been working on lately?

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 ME.  Hoenig discussed how the banking system has grown and consolidated since the 1980s and how fragile the leverage and financial structure is for the largest financial institutions.  The Dodd-Frank Act was to end reliance on government-funded bailouts when the largest, most complicated financial firms fail.  How soon we forget, but in 2008 the global financial system nearly sank into a collapse that could have rivaled the Great Depression.  Only through extraordinary government financial system bailout efforts coordinated worldwide, did it become a Great Recession.  We recovered in five years, instead of ten years like the 1930s.

 BF.  As I recall, the Dodd-Frank Legislation that Congress subsequently passed required the largest financial institutions to have a well-developed restructuring plan or “Living Will” for resolving losses and managing risks that could be implemented when necessary.  Dodd-Frank Act established bankruptcy for the largest financial institutions as the means to reposition or restructure the failed firms.  In doing so, it attempted to assure a more resilient financial system without more government bailouts.

 ME.  Correct. But Hoenig's analysis presented at his lecture raised red flags, suggesting that the financial structure of the largest financial institutions are still highly leveraged and precarious in that reserves are not sufficient enough to carry the institutions through another similar global downturn.   FDIC was created in 1933 in response to the thousands of bank failures that occurred in the 1920s and early 1930s.  As an independent agency, FDIC was created by Congress to maintain stability and public confidence in the nation's banking system. 

 BF.  FDIC is one of several financial system regulators with authority to conduct examinations of local banking institutions.  FDIC attempts to preserve and promote public confidence by insuring depositors for at least $250,000 per insured bank.  FDIC has responsibility for identifying, monitoring and addressing risks to the deposit insurance funds.  Also FDIC is directed to limit the effect on the economy and the financial system, when a bank or thrift institution fails. 

 ME. In a Statement last August, Hoenig said that all of the “Living Will” plans being developed by the large institutions were deficient and failed to convincingly demonstrate how, in failure, any of the firms could overcome obstacles to entering bankruptcy without causing a financial crisis.  “Despite the thousands of pages of material these firms submitted,” Hoenig said, “the plans provided no credible or clear path through bankruptcy that doesn't require unrealistic assumptions and direct or indirect public support.”

 BF.  Well is it is true that the largest financial institutions are generally more complicated and more interconnected than they were prior to the crisis of 2008.  They continue to combine commercial banking, investment banking, and broker-dealer activities.   According to Hoenig's statistics, the eight largest U.S. banking firms have assets equivalent to 65 percent of GDP and the average notional value of derivatives for the three largest U.S. banking firms at year-end 2013 have increased 30 percent over their level at the start of the crisis.

 ME.  Hoenig also claims there have been no fundamental changes in the reliance of the largest financial institutions on wholesale funding markets, bank-like money market funds, or other activities that have proven to be major sources of volatility.  And, when failure is imminent, no firm has yet shown how it will access private sector “debtor in possession” financing, which he considers to be a critical element in restructuring a firm.

 BF.  Thank goodness for a growing U.S. economy.  The growing economy is providing additional time for the largest banking institutions to lower their leverage, increase their capital, and moderate the risks in their portfolio.  We have seen 4.6% and 3.5% growth in GDP during the second and third quarters of 2014.  That exceeds the long run average of 3.27 % GDP growth from 1947 to 2014.  Low interest rates and lower gas prices at the pump are helping to stimulate the domestic economy.

 ME.  Yes but Hoenig, says that while the most complicated large firms may have added some capital as a funding source, they have only marginally strengthened their balance sheets to facilitate their resolvability, should it be necessary. They remain excessively leveraged in his opinion with ratios of nearly 22 to 1 on average. The remainder of the industry that includes much smaller community and regional banks averages leverage ratios closer to 12 to 1.  Hoenig suggested a tangible capital ratio of 7 to 1 would be even better.  That would be something like a 15 percent capital reserve--long regarded as a conservative banking industry standard.  Hoenig's point is that the margin for error in a possible default for the largest financial firms is nearly half that of other commercial banks that are far less important to the over soundness of the global financial system. 

 BF.  An added concern is that countries may begin to protect their domestic creditors and stop outflows of funds during a financial crisis.  That would make the problem worse.  In theory, Dodd-Frank addressed the too big to fail institutions, but in practice, it's not the law but rather its implementation that determines its effectiveness in the next downturn.

 

* Edelman is a professor of economics at Iowa State University and Flinchbaugh is an emeritus professor of agricultural economics at Kansas  State University.

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