Just Too Damn Big!

It's interesting to see the three-way debate occurring on the banking topic of Too Big To Fail (TBTF) and the six-pack of U.S. banks considered to be in that category - JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley.

On one hand, you can read an opinion piece titled "Small Banks Will Benefit From Big-Bank Breakup".  On the other hand, you can read an opinion piece titled "Small Banks Will Suffer From Big-Bank Breakups".  And on your third hand, you have the Undersecretary of the Treasury for Domestic Finance, Mary Miller, giving a speech confident that the Dodd-Frank toolkit has made TBTF a thing of the past.

Something is either lost or unspoken in the three-way mega-bank failure debate - containment of the costs of bank failure.  It's not that living wills, the bankruptcy process, and orderly liquidation authority cannot wind-down one or more of any failing so-called TBTF banks by bailing-in shareholders, creditors, and uninsured depositors.  The fact that resolution/liquidation authority is invoked in a bank failure scenario means that the bank has already burned-through higher capital requirements.  So at that point, the issues are, first, how large are the cumulative financial losses sustained by those bailed-in; and second, how will those financial losses be subsequently transmitted through the national and world economies.

Dodd-Frank limits on counter-party exposures only broaden the number of bailed-in entities, and through a negative network effect, we may have replaced the dangers of potential systemic financial collapse with a financial version of a systemic pandemic.  In medical terms, widespread illness instead of death.  There's obviously an improvement in terms of financial system stability, but not necessarily in the cumulative negative economic impacts of bank failure.  To use an internet connection analogy to illustrate a negative network effect:  too many users ( in this case, losers) can cause congestion and slow the speed of the connection and decrease the usefulness for everyone (impact on the national and world economies).

Remember the sub-prime Collateralized Debt Obligations (CDOs).  Risk managers were patting each other on the back because they had sliced and diced these financial instruments and thought they had diversified away the risk by distributing the risk to thousands of investors all over the world.  So instead of a few big losers, the smaller distributed losses dragged down economies all over the globe.

It is the size of the cumulative loss to the bailed-in shareholders, creditors, and uninsured depositors that needs to be reduced in order to limit the economic impacts of bank failure.  That argues for less market share concentration in the market for banking services in the United States and globally.

So it's not that the six-pack of  U.S. mega-banks are Too Big To Fail.  It's not that the TBTF debate is about a glass that is half-empty or half-full.  The underlying problem is that the glass is too big.  If we want to contain the economic damage from the failure of a bank, and limit contagion, the smaller the costs of bank failure, the better.

Of course, there are other relevant issues.  In testimony before the Senate Judiciary Committee, the Attorney General of the United States, Eric Holder said  "But I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if we do prosecute --- if we do bring a criminal charge --- it will have a negative impact on the national economy, perhaps even the world economy.  I think that is a function of the fact that some of these institutions have become too large." 

Set aside the academic economic minutiae-parsing and the tomato tossing by the media and community bank advocates and admit that, even with a Dodd-Frank resolution and orderly liquidation process that works, the overall societal costs of  the failure of a mega-bank continue to be source of high anxiety to most people.  It could be that the globe's largest banks are just too damn big!