Daniel K Tarullo: Confronting "too big to fail"
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal
Reserve System, at the Exchequer Club, Washington DC, 21 October 2009.
* * *
The far-reaching financial crisis that has afflicted our country in the past two years has drawn
attention to a raft of problems - from the concentration of commercial real estate exposures
in some regional and community banks, to the risks associated with some forms of
derivatives, to the need for more vigorous financial services consumer protection. Proposals
for administrative and congressional responses are thus appropriately diverse. I would
suggest, however, that the reform process cannot be judged a success unless it substantially
reduces systemic risk generally and, in particular, the too-big-to-fail problem. This afternoon I
will address my remarks specifically to the task of forging an effective response to this
problem.1
The current form of the too-big-to-fail problem
The concern is hardly a new one. In one manifestation, too big to fail was an extension of the
classic problem of bank runs and panics. If a large bank failed - whether because it was
illiquid after a deposit run or insolvent after severe losses - the entire banking system might
be endangered. In cases in which other banks held significant deposits in the distressed
institution, the failure of a large bank might lead directly to the illiquidity or insolvency of other
banks. The result could be a domino effect in the interbank lending market, with one bank's
failure toppling the next. Even where direct losses to other banks were thought manageable,
the failure of a large bank might strike panic into depositors, especially uninsured depositors,
of other large institutions. The result might be a far-reaching run on the entire banking
system that could, in a worst case such as occurred in early 1933, freeze the financial
system completely.
Faced with either variant of such a devastating impact on the system, government authorities
often believe they have little choice but to intervene. The government may provide funds or
guarantees to the bank in order to keep it functioning. Alternatively, the government may
allow the bank to fail, but shield some or all of its depositors from loss, even those not
covered by existing insurance programs. In 1984, for example, the Federal Deposit
Insurance Corporation protected the uninsured depositors of Continental Illinois Bank, then
the nation's seventh largest depository institution, after a foreign depositor run that followed
heavy losses.
One concern arises from the effects on incentives of bank creditors and, possibly, the banks
themselves. Creditors who believe that an institution will be regarded by the government as
too big to fail may not price into their extensions of credit the full risk assumed by the
institution. That, of course, is the very definition of moral hazard. Thus the institution has
funds available to it at a price that does fully internalize the social costs associated with its
operations. The consequences are a diminution of market discipline, inefficient allocation of
capital, the socialization of losses from supposedly market-based activities, and a
competitive advantage for the large institution compared to smaller banks.
The management and shareholders of the too-big-to-fail institution may, in turn, regard
themselves as holding a kind of put option and may thus be motivated to take greater risks
with the cheaper funds now available to them. If the risky projects pay off, the shareholders
profit famously. If the results are bad, the government may keep the institution afloat, thereby
preserving at least some value for shareholders.
The roots of the present crisis - and thus of the current form of the too-big-to-fail problems -
reach much deeper than the breakdown of private risk management and shortcomings of
government regulation during the first part of this decade. Its origins lie in 30 years of change
in the organization of financial firms and markets that squeezed the traditional business
model of commercial banking. The regulatory system accommodated the growth of capital
market alternatives to traditional financing by relaxing many restrictions on the type and
geographic scope of bank activities, and virtually all restrictions on affiliations between banks
and non-bank financial firms. The result was a financial services industry dominated by one
set of very large financial holding companies centered on a large commercial bank and
another set of very large financial institutions not subject to prudential regulation.
Many firms of both types relied for a considerable portion of their financing on short-term
capital market sources that were often poorly matched with the maturity structure of a firm's
assets. Securitization markets were a major part of these complex, tightly wound financial
arrangements. When questions arose about the quality of assets held by the borrowing
institutions, a classic adverse feedback loop ensued. With lenders increasingly unwilling to
extend credit against these assets, liquidity-strained institutions made increasingly distressed
asset sales, which placed additional downward pressure on asset prices, leading to margin
calls for leveraged actors and mark-to-market losses for all holders of the assets.
As shown by the intervention of the government when Bear Stearns, AIG, Fannie Mae, and
Freddie Mac were failing and by the repercussions from the bankruptcy of Lehman Brothers,
the universe of financial firms that appeared too big to fail by 2008 included more than the
insured depository institutions subject to prudential regulatory requirements. It is noteworthy
that, prior to the start of the crisis, relatively few market observers would likely have identified
Bear Stearns as so systemically important that it could not be permitted to fail in a
"disorderly" fashion. Indeed, some observers counseled letting the firm enter bankruptcy. The
extension of funds by the Treasury Department from the Troubled Asset Relief Program and
guarantees from the Temporary Liquidity Guarantee Program to each of the nation's largest
institutions in the fall of 2008 revealed the government's view that a very real threat to the
nation's entire financial system was best addressed by shoring up the nation's largest
financial firms.
The government-arranged and subsidized absorption of Bear Stearns into JPMorgan Chase
draws attention to two additional features of the too-big-to-fail problem. First, no matter what
its general economic policy principles, a government faced with the possibility of a cascading
financial crisis that could bring down its national economy tends to err on the side of
intervention. Second, once a government has obviously extended the reach of its safety net,
moral hazard problems are compounded, as market actors may expect similarly situated
firms to be rescued in the future. Both these observations underscore the importance of
adopting robust policies in non-crisis times that will diminish the chances that, in some future
period of financial distress, a government will believe it must intervene to prevent the failure
of a large financial institution.
A program to contain the problem
Moral hazard is, if not quite pervasive, certainly common in modern economic life. The best
evidence that we are willing to live with some degree of moral hazard may be found in the
importance of insurance as a social institution. The costs that would be incurred in trying to
eliminate moral hazard completely from, say, a casualty insurance policy are simply too high
as a practical matter. Similarly, we should not realistically expect to eliminate moral hazard
completely in the financial sector. What we can reasonably expect and, indeed, should insist
upon, is that we take steps to contain the problem such that the social costs associated with
the consequences of the misaligned incentives do not exceed the benefits associated with
the operation of the institutions or markets in which the moral hazard exists.
Parallel reasoning applies with respect to the negative effects that may attend the failure of a
large financial institution. Efforts should be made to reduce those effects, but in such a way
that takes account of the costs that these efforts may themselves impose on productive
activities. In the financial arena, the trade-off is often characterized as one between the
availability and efficient allocation of credit, on the one hand, and the safety and soundness
of the financial system on the other.
The conventional response to moral hazard problems arising from anticipated government
support for financial actors has been to enact regulation to counteract unwelcome effects on
the incentives of creditors, investors, or managers. Thus, for example, the potential moral
hazard arising from the availability of discount window lending or from the presence of
federal deposit insurance is offset to some degree through safety and soundness regulation.
Likewise, the potential for large negative externalities from a firm's activities is often
countered with regulation designed to force some measure of social cost internalization by
the firm.
A regulatory response for the too-big-to-fail problem would enhance the safety and
soundness of large financial institutions and thereby reduce the likelihood of severe financial
distress that could raise the prospect of systemic effects. Such a response consists of three
elements.
First, the shortcomings of the regulations that failed to protect the stability of the firms and
the financial system need to be rectified. Regulatory capital requirements can balance the
incentive to excessive risk-taking that may arise when there is believed to be government
support for a firm, or at least some of its liabilities. There is little doubt that capital levels prior
to the crisis were insufficient to serve their functions as an adequate constraint on leverage
and a buffer against loss. The Federal Reserve has worked with other U.S. and foreign
supervisors to strengthen capital, liquidity, and risk-management requirements for banking
organizations. In particular, higher capital requirements for trading activities and
securitization exposures have already been agreed. Work continues on improving the quality
of capital and counteracting the procyclical tendencies of important areas of financial
regulation, such as capital and accounting standards.
These regulatory changes are surely a necessary part of a response to the too-big-to-fail
problem, but there is good reason to doubt that they are sufficient. Generally applicable
capital and other regulatory requirements do not take account of the specifically systemic
consequences of the failure of a large institution. It is for this reason that many have
proposed a second kind of regulatory response - a special charge, possibly a special capital
requirement, based on the systemic importance of a firm. Ideally, this requirement would be
calibrated so as to begin to bite gradually as a firm's systemic importance increased, so as to
avoid the need for identifying which firms are considered too-big-to-fail and, thereby, perhaps
increasing
moral hazard.
While very appealing in concept, developing an appropriate metric for such a requirement is
not an easy exercise. There is much attention being devoted to this effort - within the U.S.
banking agencies, in international fora, and among academics - but at this moment there is
no specific proposal that has gathered a critical mass of support.
A third regulatory change is in some respects the most obvious and straightforward: Any firm
whose failure could have serious systemic consequences ought to be subject to regulatory
requirements such as those I have just described. At present, these apply only to firms that
own a commercial bank - a regulatory gap that became painfully evident last year as
systemic problems arose from the activities of other firms. Although the five large,
"freestanding" investment banks of early 2008 have subsequently either converted to bank
holding company status or ceased operations as independent firms, action by Congress is
needed to ensure that other firms posing such a risk - now or in the future - can be brought
within the perimeter of regulation.
This regulatory agenda has much to be said for it and should, I believe, be vigorously
pursued. But I doubt that rules directed at the conduct of financial firms will be an adequate
response to the too-big-to-fail problem. In the first place, there is some danger that simply
piling on a series of administrative reforms and restrictions intended to constrain the behavior
of firms would have unnecessarily adverse consequences for the availability of credit on
risksensible terms for consumers and businesses alike. The interaction of regulatory changes
needs to be thought through. Also, the financial crisis should itself inject a considerable dose
of humility into regulators' assessment of the efficacy of even well-considered regulations.
Rules directed at the behavior of large firms must be complemented with reforms directed at
the behavior of their investors and counterparties.
An agenda to enhance market discipline can serve two purposes. First, establishing the
realistic prospect of losses for investors and counterparties in a large financial institution
should change their calculations in deciding whether to enter a transaction with the firm, and
thus lead to a more complete incorporation of risk into the terms of such a transaction.
Second, the assessment of that risk by these financial actors, as reflected in the pricing of
their investments and contracts with a firm, can itself provide valuable information to
regulators.
While the role of market discipline has been much discussed in academic and policy
literature as a potentially central element of a financial regulatory system, it had not been
significantly developed and implemented by regulators themselves. The crisis has pushed
some market discipline ideas to the fore. Here again, I think there are three important
measures.
First would be creation by Congress of a special resolution procedure for systemically
important financial firms. The Federal Deposit Insurance Act establishes such a process for
banks, but not for the holding companies of which they are part, or for important financial
firms that do not own commercial banks. A regime that raised the real prospect of losses for
shareholders and creditors would add a third alternative to the unattractive existing options of
bailout or disorderly bankruptcy. The consequent increase in market discipline before severe
financial distress arises could be a key advance in the containment of the too-big-to-fail
problem.
A related innovation would be a requirement that each major financial institution draw up and
submit for approval to its supervisors a plan for orderly wind-down in the event of serious
liquidity or solvency difficulties. Although even a good faith effort might not anticipate all the
circumstances that may raise such difficulties, and thus might not adequately prepare an
effective wind-down strategy, the development of such a plan would at the least be a useful
supervisory exercise. It would, for example, provide an occasion for examining the
relationships among the many separate corporate entities within a large financial
organization.
A second kind of market discipline initiative is a requirement that large financial firms have
specified forms of "contingent capital." Numerous variants on this basic idea have been
proposed over the past several years. While all are intended to provide a firm with an
increased capital buffer from private sources at the moment when it is most needed, some
also hold significant promise of injecting market discipline into the firm. For example, a
regularly issued special debt instrument that would convert to equity during times of financial
distress could add market discipline both through the pricing of newly issued instruments and
through the interests of current shareholders in avoiding dilution.
third
A improvement in market discipline could come through judicious extension of
disclosure requirements for regulated financial institutions. Disclosure requirements have at
times served as too easy an answer to calls for market discipline. Indeed, poorly crafted
requirements can simultaneously impose significant costs on firms while providing little useful
information to investors. However, an organized inquiry of actual and potential investors
might identify discrete categories of information thought to have particular salience for
purchase and pricing decisions. There may be a need to resolve issues of potential
competitive harm to firms required to publish certain forms of information. Still, such an effort
seems worth pursuing, especially in conjunction with specific proposals for contingent capital
or similar requirements.
Alternatives
The foregoing set of administrative and legislative proposals constitutes a strong reform
program to address the too-big-to-fail problem, particularly as supplemented by the greater
emphasis on horizontal reviews, creation of a quantitative surveillance mechanism, and other
supervisory changes being implemented at the Federal Reserve.2 Along with our domestic
and international colleagues, we are already working on many of these initiatives. We are
hopeful that Congress will, in its legislative response to the crisis, include a resolution
mechanism and an extension of regulation to all systemically important financial institutions.
Still, we cannot know for certain that this program, even if forcefully implemented, would
substantially contain the too-big-to-fail problem. All participants in the reform process must
continue to explore other possibilities, including some that would work more fundamental
changes in the structure of the financial industry.
One approach suggested by a number of commentators is to reverse the 30-year trend that
allowed progressively more financial activities within commercial banks and more affiliations
with non-bank financial firms. The idea is presumably to insulate insured depository
institutions from trading or other capital market activities that are thought riskier than
traditional lending functions. There are, however, at least two reasons why this strategy
seems unlikely to limit the too-big-to-fail problem to a significant degree. One is that,
historically at least, some very large institutions got themselves into a good deal of trouble
through risky lending alone. Moreover, as we have already seen in the experience with Bear
Stearns and Lehman, firms without commercial banking operations can now also pose a
toobig-to-fail threat.
Another approach would be to attack the bigness problem head-on by limiting the size or
interconnectedness of financial institutions. Some observers have even suggested that
existing large firms should be split up into smaller, not-too-big-to-fail entities, in a manner a
bit reminiscent of the break-up of AT&T in the early 1980s. Of course, the conceptual and
practical challenges in breaking up the nation's largest financial institutions would be
considerably more daunting than those faced by Judge Greene in creating four regional
operating companies and a long distance carrier out of the old AT&T. Indeed, to my
knowledge, no one has offered anything like standards for undertaking this task, much less a
blueprint for how it would be accomplished. This is, in other words, more a provocative idea
than a proposal. Like many a provocative idea, though, even in an unelaborated form it can
focus attention on the relative effectiveness of alternative policy proposals.
The fact that the largest financial firms will account for a significantly larger share of total
industry assets after the crisis than they did before can only add to the uneasiness of those
worried about the too-big-to-fail phenomenon. It is notable that current law provides very little
in the way of structural means to limit systemic risk and the too-big-to-fail problem. The
statutory prohibition on interstate acquisitions that would result in a commercial bank and its
affiliates holding more than 10 percent of insured deposits nationwide is the closest thing to
such an instrument.3 Policymakers and policy commentators alike might usefully attempt to
develop similarly discrete mechanisms that could be beneficial in containing the
too-big-tofail problem. As must be apparent from my remarks today, my strong suspicion is that an
effective response to the problem will likely require multiple, mutually reinforcing instruments.
Conclusion
In closing, let me reiterate the importance of moving ahead with the administrative and
legislative reform agenda that I have laid out this afternoon. The components of this agenda
will each be significant contributions to a more effective regulatory system. They will enhance
financial stability and increase market discipline in transactions involving large financial firms.
Of course, financial instability can occur even in the absence of serious too-big-to-fail
problems. Other reform measures - such as regulating derivatives markets and money
market funds - are thus also important to pursue. In focusing today upon measures to
mitigate too-big-to-fail problems, I mean only to suggest that no reform package should be
considered sufficient if it does not address these problems in a robust fashion. And in
suggesting that policymakers should continue to examine possible measures beyond the
current reform agenda, I certainly do not intend to suggest that the current agenda should be
delayed. I only urge that we all keep the too-big-to-fail problem front and center as the
regulatory reform effort moves forward.