Too Big to Fail: Origins, Consequences, and Outlook Robert L. Hemi It should be emphasized that th enkws expressed in thrisah-le are the author’s and not rzecessafily those of the Bank or th Federal Reserve System. I. INTRODUCTION courts. In its absence, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve have The General Accounting Office estimates the cost come to run an informal Chapter 11 for banks. of the thrift industry bailout to be around $150 billion. George Benston, professor at Emory University, Particularly since the early 198Os, deposit insurance helps his students grasp the immensity of this number and the discount window have been used to keep by asking them to imagine how hard it is to become in operation banks that otherwise would have been a millionaire. He then asks them to imagine 150,000 closed by the market. l This arrangement has been millionaires being made paupers (NW Yoz& Times, useful in that it prevents the abrupt closing of large 6/10/90). The most important lesson of the thrift banks. In contrast to corporate bankruptcy pro- debacle is the need to close insolvent and nearly ceedings, however, the decision to allow a bank to insolvent financial institutions promptly [Kane (1989); fail is made by public officials rather than the bank’s Bartholomew (199 l)]. creditors. This arrangement has delayed the resolu- tion of insolvencies. “Too big to fail” refers to the practice followed by bank regulators of protecting creditors (uninsured Section II relates the genesis of the policy of too as well as insured depositors and debt holders) of big to fail. Section III examines how it encourages large banks from loss in the event of failure. In this risk taking. Section IV advances a reform that would article, attention is focused on the resulting transfer provide deposit insurance while leaving the decision of the decision to close a troubled bank from its to close a troubled bank to bank creditors. Using this creditors to bank regulators. The paper argues that reform as a benchmark, Section V asks whether the the policy of too big to fail created in banking the changes in bank regulation mandated by the Com- same kinds of problems of timely closure that prehensive Deposit Insurance Reform and Taxpayer existed in the thrift industry. Protection Act of 1991 will ensure that banks are closed neither too soon nor too late and that banks The policy of too big to fail resulted from a take neither too much nor too little risk. fundamental deficiency in bankruptcy arrangements for banks. In banking there is no arrangement II. THE DEVELOPMENT OF analogous to that existing for nonfinancial corpo- Too BIG TO FAIL rations unable to meet their debts, where the troubled corporation continues to operate while its A. A Brief History of Restrictions on Bank creditors determine whether it is viable. It is usually Competition undesirable to liquidate a large corporation immedi- ately following a failure to pay its debts. The cor- Free entry, the sine qua non of competition, has poration may be viable if restructured. Also, an never had the constitutional protection in banking orderly, rather than an immediate, liquidation can that it has in other industries. The Constitution increase the salvageable value of its assets. For non- financial corporations, therefore, Chapter 11 of the r The FDIC has argued that the policy of too big to fail has been bankruptcy law provides a procedure under which imposed on it by statutory restrictions that require the least costly method of resolving a bank failure. Specifically, the FDIC can a bankruptcy judge supervises the operation of a economically liquidate a small bank, but not a large one. Large corporation that cannot pay its debts. Creditors and bank failures, consequently, are handled bv ourchase and existing management then negotiate whether to assumption arrangements, which avoid liquidation, but require the FDIC to iniect enough funds into the sale of closed banks liquidate or restructure. to restore thei; solvency and to avoid depositor losses. This situation reflects the absence of a Chapter 11 arrangement for Banks are not subject to bankruptcy law. For banks that would allow either the market or regulators to close banks, there is no Chapter 11 administered by the banks without forcing immediate liquidations. FEDERAL RESERVE BANK OF RICHMbND 3 prohibits states from interfering with trade across separate industries that could not compete with each their boundaries. The commerce clause (Article I, other. Glass-Steagall separated fund-raising for cor- Sec. 9) states, “No tax or duty shall be laid on porations into banking and securities industries. articles exported from any state.” In 1869, in Paul Insurance companies, savings and loans, and credit v. Virginia, the Supreme Court extended the pro- unions were assigned their own regulators and tection of the interstate commerce clause to corpora- spheres of influence. The Banking Act of 1933 pro- tions by ruling that a state could not exclude an hibited the payment of interest on demand deposits, out-of-state corporation from doing business in it. and Regulation Q limited the interest banks could [See Butler (1982), especially Ch. IV.] Banks are pay on time and savings deposits. Later, the 1956 engaged in commerce in the sense that they are Bank Holding Company Act restricted the ability of middlemen. They make money on the difference banks to operate nationally through multibank between the rates at which they borrow and lend. holding companies. Justice Department antitrust It has never been acceptable politically, however, to guidelines restricted competition by limiting the extend to banking the constitutional protection of ability of banks to acquire other banks. free entry across state boundaries accorded other corporations.z B. Increased Competition for Banks The ability of states to exclude out-of-state banks allowed state legislatures to organize their intrastate Beginning in the late 196Os, innovations in com- banking industries into a large number of small banks, munications and computer technology eroded re- each of which enjoyed some local monopoly power. strictions on competition in banking by making it Around the turn of the century, when the demand possible for nonbank institutions like money market for banking services grew in rural areas, state mutual funds to offer bank-like services to bank legislatures passed laws prohibiting banks from customers. By lowering the cost of bookkeeping and meeting this demand through branching. By 1929, disseminating information, this technology lessened almost all states had laws either prohibiting or re- the advantage that banks had possessed formerly in stricting intrastate branching. Along with low capital gathering deposits and monitoring the credit risk of requirements for establishing a bank, the result was borrowers. The emergence of new competitors to a banking industry consisting of large numbers of unit banks has reduced the viable size of the traditional banks. The National Banking Act included ambig- banking industry. uous language that was often interpreted as forbid- ding interstate branching by national banks. In 1927, The dramatic increase in competition facing banks the McFadden Act eliminated any ambiguity by is apparent in the minimal extent to which businesses specifically prohibiting national banks from branching relied on domestic banks in 1990 for additional credit. across state lines. As a result, banks could not diver- Baer and Brewer (199 1) report the following statistics. sify geographically their loans and the sources of their In 1990, business credit provided by domestic banks, deposits. [For a history of prohibitions on branching, finance companies, U.S. branches of foreign banks, see Mengle (1990)]. offshore sources, and by nonfinancial commercial paper grew 7.3 percent. Domestic banks provided Competition in banking was further restricted only a small fraction, 7 percent, of this growth in during the Depression. At the time, many blamed funding. The year 1990 was unusual in that many the Depression on excessive competition. It appeared banks were attempting to increase their capital-to- plausible that individual insolvent firms could be asset ratios by restricting asset growth. The figures made solvent by restricting competition. In many reflect, however, a longer-run decline in bank industries, consequently, government regulation business lending. Over the decade of the 198Os, attempted to raise prices by restricting competition. banks’ share of short- and medium-term lending to The government divided financial intermediation into businesses declined at an annual rate of 1.5 percent. Furthermore, as Baer and Brewer point out, the 2 Ironically, the European Common Market is using the U.S. market is continuing to develop new substitutes for federal model to promote open competition in banking. Start- bank lending like asset-backed commercial paper ing in 1993, banks will be free to branch across national boun- daries. Furthermore, in general, host-country regulators cannot (backed by trade receivables) and prime rate funds place any restrictions on the activities of branches of foreign banks (backed by commercial loans). These sources, which not imposed by the home-country regulator. [See Coleman and are not included in the above sources, added about Hart (7/29/9 l).] The combination of guaranteed free entry and home-country regulation sharply curtails the ability of host- two percentage points in 1990 to growth in short- country regulators to limit competition in the banking industry. term business credit. 4 ECONOMIC REVIEW. NOVEMBER/DECEMBER 1991 Beginning in the last half of the 196Os, a series of possessed by banks to transform a portfolio of illi- financial innovations eroded regulatory restrictions quid assets into liquid liabilities. Securitization has on competition in deposit gathering. High market increased the range of financial intermediaries that rates of interest produced by high rates of inflation can hold the illiquid assets formerly held only by generated incentives to escape the low ceilings on banks.