Is Fed Endorsing Ending to Too Big to Fail?

Annual reports from financial
institutions rarely make the best seller list, but the one published by the
Federal Reserve Bank of Dallas is beginning to rocket around the Internet
because of an essay it contains.  The
essay, written by Harvey Rosenblum, Executive Vice President and Director of
Research at the Bank is titled “Choosing the Road to Prosperity:  Why We Must End Too Big to Fail – Now.

The essay is stunning enough in and by
itself, but in an accompanying cover letter the Dallas Fed’s President Richard
Fisher expressly endorses it, in effect putting at least a part of the Federal
Reserve System on record as advocating an end to Too Big to Fail (TBTF) institutions. 

“In addition to remaining a lingering threat to
financial stability,” Fisher says, “these mega banks significantly hamper the
Federal Reserve’s ability to properly conduct monetary policy.”  Likening the economy to a car he said that
the Fed had filed the tank with plenty of cheap, high-octane gasoline, but it
takes more than gas to propel a car.  “If
there is sludge on the crankshaft – in the form of losses and bad loans on the
balance sheets of the TBTF banks – then the bank-capital linkage that greases the
engine of monetary policy does not function properly to drive the real
economy.  No amount of liquidity provided
by the Federal Reserve can change this.”

TBTF has also resulted in an erosion of faith in American capitalism, he said,
and diverse groups “argue that government-assisted bailouts of reckless
financial institutions are sociologically and politically offensive.  From an economic perspective, these bailouts
are certainly harmful to efficient workings of the market.”

tracks the downfall of the economy but less as a tick-tock than as a
sociological study.  It is long and
difficult to summarize so we will do so in two parts.

*  *

Good times
breed complacency, not right away but over time, as memories of past setbacks
fade.  In 1983 the U.S. entered a 25 year
span interrupted by only two brief shallow downturns accounting for just 5
percent of that period.  There was strong
growth, low unemployment and stable prices.

Before the
Federal Reserve was founded in 1913 the economy spent 48 percent of the time in
recession, in the 99 years since recessions have affected the economy only 21
percent of the time.  “When calamities
don’t occur, it’s human nature to stop worrying.  The world seems less risky.”

In the
run-up to 2008 the public sector grew complacent and relaxed the
financial systems constraints, explicitly in law and implicitly in enforcement,
and felt secure enough to pursue social engineering goals such as expanding
home ownership.  The private sector also
became complacent, downplaying the risks of borrowing and lending.

There was greed;
capitalism cannot operate without self-interest and most of the time competition
and laws keep it in check.  But when
competition declines incentives often turn perverse and self-interest can
become malevolent.  That’s what happened
in the years before the financial crisis. 
New technologies and business practices reduced “skin in the game,” and
greed led “innovative legal minds” to push boundaries of integrity.

led to complicity.  The banks were
making money, investors wanted part of it, and credit rating agencies got
involved.  The Fed kept interests rates
too low too long, contributing to the speculative binge in housing and pushing
investors to seek higher rewards in riskier markets.  “Hindsight leaves us wondering what financial
gurus and policymakers could have been thinking.  But complicity presupposes a willful blindness.  Why spoil the party when the economy is
growing and more people are employed? 
Imagine the political storms and public ridicule that would sweep over
anyone who tried.”

money leads to a giddy self-delusion.” 
The certainty of rising housing prices convinced some homebuyers that
high-risk mortgages weren’t that risky; that draining equity to pay for new
cars or a vacation was prudent.  Buying
into the exuberance gave people what they wanted, at least for a while.

traits, complacency, greed, complicity, and exuberance were intertwined with
concentration, the result of a natural desire to grow bigger, more important,
and a dominant force in one’s industry. 
Concentration amplified the speed and breadth of the subsequent damage
to the banking sector and the economy as a whole.

Since the
early 1970s the share of the banking industry assets controlled by the five
largest institutions
has more than tripled from 17 percent to 52 percent.  These mammoth institutions were built on
leverage which was often hidden by off-balance sheet financing.  The equity share of assets dwindled as banks
borrowed to the hilt to chase easy profits in new, complex and risky
instruments and balance sheets deteriorated. 
Accounting expedients allowed banks to claim they were healthy until
they weren’t.  Write-downs were later
revised by several orders of magnitude to acknowledge mounting problems.

With size
came complexity as banks stretched their operations to include proprietary
trading and hedge fund investments and spread their reach into dozens of
countries.  “Complexity magnifies the
opportunities for obfuscation and top management may not have known everything
that was going on, especially in regards to risk and regulators didn’t have the
resources to oversee the banks’ vast operations.

large, complex institutions aggressively pursued profits in overheated markets,
pushed the limits of regulatory ambiguity and lax enforcement.  They carried greater risk and overestimated
their ability to manage it and in some cases top management groped around in
the dark because their monitoring systems didn’t keep pace with their expanding

A healthy
financial system keeps the economy humming and we take its routine workings for
granted – until the machinery blows a gasket. 
It was the biggest investment and commercial banks that took the first
write-offs on their mortgage backed securities in 2007 and as the housing
market continued to deteriorate policy-makers became alarmed, seeing the number
of big globally interconnected banks involved 
and fearing the loss of even one would bring the whole system down.

This fear
was justified as Lehman Brothers collapsed and credit markets froze forcing the
government to inject billions to keep other institutions afloat.   “The situation in 2008 removed any doubt that
several of the largest U.S. banks were too big to fail.” 

With the
financial system disabled, the entire system spun downward into the longest
recession in the post-World War II era.

In the second part of the essay
Rosenblum looks at the Fed’s reaction to the recession, why TBTF has stymied
recovery, and what might be done about it.

…(read more)

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