Policy Documents

Research & Commentary: Ending “Too Big to Fail”

May 15, 2013

The federal government’s “Too Big to Fail” policy remains highly unpopular with the public. Previous bank bailouts have proven to be an expensive use of taxpayer dollars and a dubious act of government interference in the market. Sens. Sherrod Brown (D-OH) and David Vitter (R-LA) have proposed new legislation that would use bank capital holding requirements to avert bank failures and subsequent bailouts. The Terminating Bailouts for Taxpayer Fairness Act would require banks to maintain significantly increased capital levels. 

The bill’s language claims U.S. bank assets have grown from 20 percent of GDP to 100 percent of GDP while banks’ capital ratios declined from about 25 percent to around 5 percent of total assets. Under the new capital requirements, banks with $500 billion or more in assets would be required to hold 15 percent, and banks in the $50 billion to $500 billion asset range would be required to hold 8 percent. Business Insider reports the Brown-Vitter bill would require smaller community and regional bank to hold $1 in equity for every $8 to $10 in assets. Larger banks would be required to keep $1 for every $15 in assets. 

The bill would limit the types of assets a bank could hold to fulfill the capital requirements by requiring them to be tangible assets with real shareholder equity. Second, the capital ratios would be based on a bank’s total assets and disallow any recalculation of capital based on risk levels while requiring the subsidiaries and affiliates of larger banks to be individually capitalized. Third, to curb the expectation of government bailouts, the bill would prohibit the Federal Reserve and other banking regulators from allowing non-depositories access to certain government support programs such as Federal Reserve discount window lending and deposit insurance. 

Although capital standards can play an important role in minimizing bank failures, the high capital requirements proposed by this bill could harm the financial and banking sectors far more than they help. This proposal would require banks to raise a great deal of cash to cover the new capital requirements, which could lead to a massive sell-off of assets or large cuts in staff.  Capital requirements also reduce the ability of banks to lend, which reduces the amount of credit available to business. The Terminating Bailouts for Taxpayer Fairness Act would do little to stop bailouts for companies considered systematically important while reducing the availability of credit and slowing economic growth.

The following articles examine bank bailouts and “Too Big to Fail” from multiple perspectives.

Too Big to Fail: Brown–Vitter Swings and Misses
James Gattuso of The Heritage Foundation criticizes Brown-Vitter and argues there is a better solution: “Rather than massive increases in capital mandates, policymakers should focus on making the failure of a large financial institution less damaging to the economy at large. The Dodd–Frank law attempts to do this through its ‘Orderly Liquidation Authority,’ although that procedure provides too much discretion to regulators in disposing of assets. But other approaches based on existing bankruptcy law show promise.” 

Two Senators Just Introduced a Bill That Could Neuter Wall Street
Linette Lopez writes in Business Insider about the Brown-Vitter bill and the deleterious effects the new capital requirements could have on Wall Street and the economy.

Dodd-Frank Not Likely to End Bailouts as Promised
Writing in the Heartlander digital magazine, Thomas Jacobs of DePaul University argues the Dodd-Frank regulations are unlikely to end bailouts. “Bailouts are an attempt to prevent something worse such as the collapse of the financial system,” he writes. “As there is no test to confirm the systemic risk of a financial firm in advance, a regulator will choose taxpayer-funded support of the firm over risking the demise of the financial system. Although the Boxer amendment to Dodd-Frank prevents the use of taxpayer funds to avoid liquidation of troubled financial firms, Dodd-Frank and its regulatory implementation to date leave plenty of bailout loopholes. Consider three mechanisms: markets with inherent systemic risk, the regulation of firms prior to financial distress, and the resolution of distressed firms.” 

Brown-Vitter: More Hot Air
Louise Bennetts of the Cato Institute identifies several flaws in the Brown-Vitter bill that indicate a misunderstanding of what caused the financial crisis and bailouts. “Essentially, the only way to end the perception of a government backstop is to put in place a credible system to allow large firms to fail if they make poor decisions. To this end, the Brown-Vitter Bill doesn’t add anything except more confusion.”

Using Bankruptcy and Capital Standards to Address Financial Institutions That Are “Too Big to Fail”
David John of The Heritage Foundation examines the proposed use of capital and bankruptcy standards to end TBTF. Instead of giving government regulators almost unlimited powers to take over or micromanage financial institutions, John argues a better choice would be to “amend U.S. bankruptcy law to create an open, expedited bankruptcy process in which an impartial court would oversee the restructuring or closure of large and complex financial firms. In addition, increasing financial institutions’ capital requirements would reduce risk to the system and limit losses if a financial crisis occurs.” 

The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences
David A. Skeel Jr. of the University of Pennsylvania Law School examines the various components of Dodd-Frank and how they are intended to work. He suggests several simple bankruptcy reforms that would curb the excesses of the new government-bank partnership, plus ways to address international dimensions of the new financial order he maintains Dodd-Frank largely neglected.

The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-To-Fail Problem
Arthur E. Wilmarth Jr. of the George Washington University Law School considers whether the new statute is likely to solve the Too-Big-To-Fail Problem. He discusses several alternatives or changes to Dodd-Frank for approaching the problem.

The Financial Turmoil of 2007-XX: Sinners and Their Sins
George Kaufman of Loyola University Chicago and the Federal Reserve Bank of Chicago identifies the main culprits or sinners and the major sins they committed in the financial crisis that started in the summer of 2007. Interest rate policy is among the issues discussed. 

Too Big to Fail in Banking: What Does it Mean?
Too Big to Fail has become a major public policy issue that has not been resolved, in part because of disagreements about definitions and the resulting estimates of benefits and costs. George Kaufman of Loyola University Chicago and the Federal Reserve Bank of Chicago explores these differences and develops a framework for standardizing the definitions and more accurately evaluating the desirability of TBTF resolutions. 

Bailouts: Government’s Project to Finance Failure
Independent Institute Research Fellow Vern McKinley examines the financial bailouts and “too big to fail” and argues that although federal financial regulators and politicians claim to have saved the U.S. economy, they have in fact done everything within their power to expand their own influence—often far out of view from the public and media. “Instead of openly explaining their actions, the bailout agencies have attempted to prevent the public from reviewing their decision-making, often at tremendous cost to taxpayers,” he writes.

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit The Heartlander’s Finance and Insurance News Web site at http://news.heartland.org/insurance-and-finance, The Heartland Institute’s Web site at www.heartland.org, and PolicyBot, Heartland’s free online research database, at www.policybot.org.

If you have any questions about this issue or The Heartland Institute, contact Heartland Institute Senior Policy Analyst Matthew Glans at 312/377-4000 or mglans@heartland.org.