Two weeks ago, the U.S. Treasury Department, in a report released by the Government Accountability Office (GAO), assuaged policy-maker and taxpayer concerns that a repeat big-bank bailout would not be a necessary damage control tool in the face of future financial duress.
The study claimed that safeguards associated with the Dodd-Frank Act of 2010 have succeeded in diminishing the advantages from which big banks benefitted during the crisis relative to their smaller-sized counterparts. The findings even led treasury undersecretary Mary Miller to state, “We believe these results reflect increased market recognition of what should now be evident — Dodd-Frank ended ‘too big to fail’ as a matter of law.”
Not two weeks later, on the heels of the GAO report, the Federal Deposit Insurance Corporation (FDIC) released a staggering assessment of big-bank’s state of compliance (or lack thereof) with Dodd-Frank and, in particular, the Orderly Liquidation Authority. That’s the provision by which troubled banks may be systematically and safely dismantled when facing bankruptcy or insolvency without taking the entire economy down too.
After already returning the first round of “living wills” that the biggest U.S. banks were required to submit to officials in accord with Dodd-Frank two years ago, regulators again declared the proposed pathways to safe restructuring in the face of financial duress terribly inadequate — all 11 of the banks in question failed.
In noting the insufficiency of plans for circumventing systemic damage to markets when the most complex balance sheets go bad, the FDIC noted banks “are not credible and do not facilitate an orderly resolution under the U.S. Bankruptcy Code.”
The FDIC cited, among other shortcomings of the “living wills,” “failures to address structural and organizational impediments to an orderly resolution.”
The more optimistic GAO report did show evidence that the enlarged gap of borrowing advantages experienced by banks with the most assets relative to community-sized banks has diminished over the last four years.
The “too big to fail” advantages of 2008-09 stem from the implied subsidy to the largest of U.S. banks during the crisis in the form of lower borrowing costs driven by economies of scale, enhanced diversity of portfolios and, most importantly, the implicit impression held by lenders that bailout funds will be available if needed, and so on.
To be sure, large financial institutions benefit from lower borrowing costs relative to community banks during financial crises and times of grave economic uncertainty because they are, generally speaking, more stable and possess greater liquidity – the ease with which an asset can be converted into cash.
The spirit of Dodd-Frank was to mitigate financial market distortions through increased capital and liquidity standards, enhanced informational transparency of loan originators and credit rating agencies and greater oversight of OTC derivatives markets. The most critical pillar of Dodd-Frank for eradicating the need to bailout mega banks in the future, however, is the development of OLA and the banks are not currently up to par.
Regulatory officials are claiming that there are several reasons for the failed tests.
First, the FDIC vice chairman Thomas Hoenig noted that the largest U.S. banks today are even more complicated than they were leading up to and during the crisis.
Second, bank leverage ratios — the proportion of liabilities and shareholder equity that the firm is using to finance their assets — sits around 22:1 for the largest banks; down from 35:1 during the crisis but still dangerously high.
To have a bankruptcy of a mega-institution unfold safely whereby associated costs are largely internalized, as opposed to financed through taxpayer funds, greater capital buffers need to be in place to weather declines in asset value without leading to negative net worth.
While its benefits for safeguarding against collapse are well understood in macroprudential policy circles, capital requirements of, say, 12 to 16 percent of total assets — double the current international requirement — has been a tough sell in Washington and abroad.
Nicholas J. Mangee is an assistant professor of economics at Armstrong State University and can be reached at Nicholas.mangee@armstrong.edu.
By Nichols J. Mangee