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Does Brexit give us our best chance to kill too-big-to-fail?

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The biggest U.S. banks are the strongest in the world, which is why we should break them up right now. They just passed the Federal Reserve’s annual “stress tests,” and they navigated smoothly the moderate stresses of post-Brexit financial markets turmoil, which has shaken many big European banks.

The alternative to break-up is Dodd Frank, the 2010 bank law that, instead, employs intensive regulation to ensure the safety of our “too-big-to-fail” banks. Recently, both the Federal Reserve and the House GOP announced proposals with the idea of ensuring bank safety without such smothering government oversight.

Both the Fed and House GOP proposed increased equity capital standards. However, they head in exactly opposite directions.

The Fed, whose proposed standard would apply only to big banks, is pushing implicitly for break-up, with Fed Governor Jerome Powell saying the point is to “raise capital requirements to the point at which it (whether to break-up) becomes a question that banks have to ask themselves.” The House GOP ignores the “question” about size and offers effective exemption from Dodd Frank to any bank that meets certain conditions, primarily an even higher, but voluntary, capital standard (a 10% equity ratio), designed to be virtually absolute protection against failure.

The outright break-up option has always had the simplest logic: it takes the “too” out of too-big-to-fail. Dodd-Frank also employs break-up, but only as a contingency plan. Big banks must maintain “living wills,” plans by which they would be broken up if they get into trouble. However, in contrast with the recent stress test outcomes, most of the “wills” submitted to date have been found by regulators to be inadequate, so how workable are they?

Interestingly, the Fed is not the only voice calling for break-up. So is the stock market, because ultrahigh capital levels make it too difficult for banks to earn a return on capital for shareholders.

Indeed, bank advisory firm, Keefe Bruyette & Woods, has estimated that Citigroup’s market value would increase 60%, if it sold its global consumer business and split its remaining operations into two smaller banks not required to hold extra capital. Citigroup management has long been rumored to be considering break-up.

In apparent sensitivity to this excess-equity-capital problem, the Fed has proposed that banks be required to issue “bail-in bonds,” a novel form of debt that would automatically convert into loss-absorbing equity in event of bank failure. The concept has met a mixed reception, with Thomas Hoenig, Vice Chair of the FDIC, warning that the idea might actually “undermine the financial stability being sought.”

A forced break-up now when the big banks and the economy are stable would be far safer than a break-up during the kind of unstable or crisis conditions which would cause a failure and trigger “living wills” and conversion of “bail-in bonds,” something which Neil Kashkari, President of the Minneapolis Federal Reserve Bank, has likened to “dismantling an aircraft carrier in the middle of a hurricane.”

So what happens if we do nothing and a big bank fails, as eventually one will?

Consider the 1984 failure of Continental Illinois, then the nation’s seventh-largest bank.

The FDIC told Congress that it couldn’t resolve Continental’s failure by the standard method, an arranged takeover by a bigger stronger bank, because Continental was too large for any of the nation’s six larger banks. Connecticut Congressman Stewart McKinney observed “It’s too big to fail.”

As coined, the term had little to do with systemic risk — Continental held only about 2% of all bank industry assets. Instead, it signified the inability to resolve failure by standard means. Obviously, for the “biggest banks,” there will never be a “bigger, stronger” acquirer.

There are only three resolution options for the biggest bank failures. Continental illustrates one, nationalization. The government took it over and operated it for a decade. Nationalization puts the government directly in charge of credit allocation, undermining our free enterprise system which depends upon a free private banking system.

The preferred option is dismantlement and sell-off of the parts, whose great difficulty Continental also demonstrates, since Continental wasn’t resolved this way. There’s little confidence that “living wills” and “bail-in bonds” would make a sell-off more likely to succeed today.

The third option is recapitalization/massive government assistance — in other words, bailout. To survive its losses during and after the 2008 financial crisis, Citigroup required various forms of assistance totaling about $400 billion, or 20% of its approximately $2 trillion in assets, or twice the supposedly super-safe equity capital level proposed by the House GOP.

No one wants nationalizations or bailouts, and “living wills” and “bail-in bonds” are untested and complex ideas at best – and the stakes are higher than ever, since our big banks are bigger than ever. Each of our four largest banks holds about 10% to 15% of the nation’s banking assets. Such concentration violates basic portfolio theory which says the best way to reduce risk is to spread it across many entities.

It is time to break up our giant banks. Not to do so is to kick the can down the road with only bad or unproven options available when one does fail. In the meantime, it leaves them smothered under Dodd Frank’s excessive regulation. Overregulation itself constitutes a form of nationalization.

Within broad parameters, let the big banks choose how to break themselves up. But do it now.


As appeared in Investor’s Business Daily on July 16, 2016.


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