Too Big to Fail

By Mark A. Calabria

There is perhaps no issue that drove the passage of the Dodd-Frank Act more than the public perception that certain large institutions enjoyed the backing of the federal government. A situation commonly called “too big to fail” (TBTF). Not by coincidence the first two titles of Dodd-Frank are aimed at addressing, some might claim ending, the too-big-to-fail status of our largest financial institutions. Here I raise a number of concerns and observations that merit meeting the claim of ending TBTF with considerable skepticism.



One reason that debates over TBTF are often so heated is that there is no actual explicit subsidy provided on-budget for such purpose. We can (and should) debate the merits and effects of deposit insurance, for instance, but we don’t debate its existence. It is there. Whether TBTF is real or not is a far trickier question. We are left with no choice but looking for “clues”.
The first clue is the actual text of Dodd-Frank. There is, of course, flowery language about “eliminating expectations…that the Government will shield” parties from losses “in the event of a failure”. But as any first law student should know, vague purposes do not constrain explicit authorities. And Dodd-Frank is quite explicit. Section 204, for instance, is quite clear that the Federal Deposit Insurance Corporation (FDIC) can purchase any debt obligation at par (or even above) of a failing institution. If rescuing a creditor at par is not the very definition of TBTF, I’m not sure what is. Section 201 goes even further by allowing the FDIC to pay “any obligations…” it believes are “necessary and appropriate”. If that sounds vague enough to drive a semi through, then you’re not alone. In fairness, Dodd-Frank does offer a path for ending TBTF without cost to the taxpayer or the rest of the financial industry. But that path is clearly an optional one.

One reason I do not believe ending TBTF will be the path taken is that this was also an option with Fannie Mae and Freddie Mac. The Housing and Economic Recovery Act of 2008 created a mechanism similar to Dodd-Frank’s Title II resolution process. It could have been used to keep Fannie and Freddie functioning without a dime of cost to the taxpayer. Instead the taxpayer was tapped. Recall that Freddie is actually smaller and far less complex than CitiBank. Defenders of Dodd-Frank have yet to offer a reason why Citi would be allowed to fail, when Freddie was not.
Speaking of Fannie Mae and Freddie Mac, the current debates over TBTF sound eerily familiar to similar debates about those companies over a decade ago. Both companies hired fancy economists like Joe Stiglitz and Glenn Hubbard to claim there was no chance of failure. The companies also hired economists to claim that Fannie and Freddie didn’t really receive a large funding advantage, such as that estimated by the Congressional Budget Office. And of course, like Dodd-Frank, the statutes governing Fannie and Freddie clearly stated (and still do) that there is no taxpayer backing. The authors of Dodd-Frank were also prominent among those claiming that there was no taxpayer backing of Fannie and Freddie, just as they claim today that Dodd-Frank ends bailouts. Let’s also not forget Dodd and Frank were also the drafts of the TARP. Not exactly a history of aversion to bailouts.
Much of the debate over TBTF has revolved around various studies as to the “size” of the subsidy. Such exercises are useful but limited. For instance raw FDIC data suggests that the largest banks enjoy a funding advantage over other banks. Yes that raw advantage has declined since the height of the crisis. One would expect such since bailouts are more likely when policy-makers are panicking. On the other hand that advantage is bigger than it was pre-crisis. Compared to the average funding costs over the last three decades, the largest banks enjoy a funding advantage of around 30 basis points, similar to that enjoyed by Fannie and Freddie pre-crisis. Even if the observed advantage disappeared, such does not mean TBTF is gone. As any first year statistics or science student learns, the absence of a finding is that the same as a finding of absence. During most of the last three decades and even up to 2007, the largest banks actually paid more to borrow than the rest. The data can at best be suggestive.
As long as we remain under a regulatory regime of vast discretionary authorities with almost unlimited pots of public money, bailouts will remain a potentiality. The best we can hope for is to have public officials adamantly opposed to bailouts. The continued rounds of “victory laps” by regulators do not offer much hope. Every time someone claims “Lehman should have been saved” or that the TARP was a “great success” the signal sent to market participants is that bailouts will be forthcoming next crisis. Fortunately markets also seem to respond to changes in leadership. Concurrent with Treasury Secretary Geithner’s retirement came a further decline in the funding advantage of our largest banks. The Senate would be wise to scrutinize future nominations on their taste for bailouts. Ultimately to achieve additional certainty on ending TBTF, we must tie the hands of our regulators, so like Ulysses, they can resist the call of the Sirens.