Does Dodd-Frank Really End ‘Too Big to Fail’?

Such is the title of this weekend’s Wonkblog article by Mike Konczal. The proper answer to that question is, “Who cares?”

Contrary to popular belief on the right and left, too big to fail was not the problem in the current crisis. Nor has it been the problem in any previous crisis. The “bigness” or “smallness” of banks is uncorrelated with the quality of its balance sheet. Just take a look at a list of TARP recipients. Try asking Spain how well the existence small lending institutions insulated their economy from collapse. In the United States, we have never experienced a problem whose proximate cause was the large size of a particular set of banks. But we have experienced the exact opposite of that problem. Twice.

The US may suffer from the size of banks, as the finance sector grabs a disproportionate share of profits (as a percentage of GDP), but that is a separate question of the ability to extract rents and long term productivity growth. What the US economy fell prey to in the subprime crisis was the homogenization of assets. This is the same issue that plagued small banks in the Great Depression, whose loan portfolios were necessarily underwritten by serially correlated assets. It is popularly known as “putting all of your eggs in one basket”.

It is important to get the idea of “too big to fail” out of peoples’ heads for the same reason that Paul Krugman thinks it’s important that we indoctrinate people with the idea “AUSTERITY=BAD”*: it leads to bad policy…and it has already led to bad policy, in the form of Dodd-Frank. The Wall Street Reform and Consumer Protection Act takes for granted that our economy faces risked correlated with the size of financial institutions, and misplaces financial regulators’ energies on systemically identifying risk, micromanaging balance sheets, and providing government agencies with the powers to assign downside risk.

This is why I stand athwart history screaming “TOO BRITTLE TO SUSTAIN“. To the extent that there was an issue with banks’ balance sheets (and tight money was the real problem), the issue was the perceived transformation of risk. Because what is now popularly referred to as “alchemy” transmogrified the perceived riskiness of underlying assets into high quality debt instruments banks held more of these types of assets at the margin, effectively homogenizing their balance sheets. As time went on, the liabilities issued tended toward homogenization as well — mortgage lending. Thus, banks (as an entire ecosystem) were collectively draining their reserve capacity. As we know from

C = A + ϕ.

The ability of an ecosystem to sustain itself (capacity, C) is determined by it’s scaled mutual constraint (A) and conditional entropy (reserve, ϕ). High serial correlations of liabilities issued and assets held completely diminished ϕ. Due to this, in the event of catastrophe (for instance, the subprime crisis), the financial system as a whole experienced severely diminished capacity (paper market dried up). When this happens in natural ecosystems, it causes extreme disease spread, unusual predation patterns, and ultimately whole ecosystem collapse. Similarly, this happens in economies as well.

Unfortunately, Dodd-Frank deals with none of this.

The discussion under way currently deals with the extent of Dodd-Frank’s uselessness. John Cochrane comments in the Wall Street Journal today in favor of eliminating the mechanisms which incentivize debt financing in the financial sector at the expense of equity financing, ultimately:

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks: “OK, cousin Louie, I’ll cosign the loan for your Las Vegas trip, but no poker this time, and be in bed by 10.”

Reihan Salam outlines specific ways in which the US government subsidizes corporate debt.

Cochrane’s solution (via Admati and Hellwig); which is endorsed by Miles Kimball in my previous discussion, as well as here, is to require higher capital ratios. Admati and Hellwig suggest that 20-30% is feasible, but Cochrane suggests that 50% (or even 100%!) is warranted by the research.

The simple existence of this question is enough to turn me off of specific capital requirements, or more squishily, punitive levels of capital requirements. Cochrane has this to say in his article:

No, they write, it was not always thus. In the 19th century, banks funded themselves with 40% to 50% capital. Depositors wouldn’t lend to banks unless the banks had a lot of skin in the game. Without a government debt guarantee—and, early on, without limited liability—shareholders wanted less risk as well.

What was the catalyst of this? Double liability. Here’s Josh Hendricksen:

The banking system in the U.S. hasn’t always been like this. Between the Civil War and the Great Depression, banks did not have limited liability. Instead, they had double liability. When a bank became insolvent, shareholders lost their initial investment (just as they do under limited liability today). But in addition, a receiver would assess the value of the asset holdings of the bank to determine the par value of the outstanding shares. Shareholders had to pay an amount that could be as high as the current value of their shares in compensation to depositors and creditors.

I think that the superiority of double liability over specific capital ratio targets is that under a more neutral incentive structure (as in, it aligns correct parties with downside risk), firms will be able to determine the correct level of equity to debt financing. This would immediately increase the reserve capacity of the financial system as a whole, which would allow the system greater ability and flexibility in absorbing shocks. Capital ratios perform this same function, but they seem too rigid to me.

The bottom line is we have misplaced our focus on individual institutions, when we should be focused on creating a sustainable ecosystem.

Update: Simon Johnson has a Bloomberg article advocating equity financing, as well.

*I don’t buy this line of thinking. In my opinion, austerity=ambiguous, bad monetary policy=bad.


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