FEATURE CONTENTS INTRODUCTION I. THE INTRACTABLE (POLITICAL) PROBLEM OF BIGNESS: HISTORY AND CONTEXT A. The Problems: Credible Commitments and Public Expectations B. The Lemmings Problem II. THE SHORTCOMING OF CURRENT LAW A. Interconnectivity and the Uncertainty of Too Big To Fail B. Antitrust: Change in Focus Needed III. TWO PROPOSED SOLUTIONS AND THE FINAL LEGISLATIVE OUTCOME A. Paul Volcker's Original Too Big To Fail Rule B. Our Proposal: The Bright-Line Limit C. Criticisms of the Bright-Line Rule D. The Dodd-Frank Act CONCLUSION INTRODUCTION
Use of a precommitment device enables a government or other entity to make a promise that it will be expected to keep in the future. A government implements a precommitment device by taking some action (like tying oneself to the mast or burning one's bridges) that eliminates its ability to take certain other actions in the future. By eliminating certain options, a government can increase the deterrence effect of a particular promise or threat by making the promise or threat far more credible. (1)
In this Feature, we analyze massive government bailouts of financial institutions as an example of a classic precommitment problem. In times of economic stability, governments understand that future bailouts of massive financial institutions will be expensive and inefficient; they will lead to significant moral hazard on the part of the financial institutions that are eligible for such bailouts. Policymakers, however, cannot credibly commit to refrain from supporting large, important financial institutions.
The government's inability to precommit to refrain from engaging in massive bailouts creates an implicit government guarantee: those institutions in this "Too Big To Fail" category will be bailed out, despite the government's inevitable prior pledges (usually made immediately after prior bailouts) to refrain from orchestrating such bailouts in the future. These implicit guarantees would be considered bad policy if articulated as explicit guarantees. Some sort of precommitment device is needed to bring to an end the vicious circle of bailouts in which the United States appears to be trapped. In our view, the only precommitment device that enables the government to make a credible promise to refrain from future massive bailouts is to act preemptively to prevent financial institutions from growing so large that they become too big to fail.
Our precommitment device takes the form of a bright-line rule that operationalizes the adage--once popular among regulators but never implemented--that "any financial institution that is too big to fail is too big to survive." What this means, as a practical matter, seems obvious: we must determine how big is Too Big To Fail and dismantle institutions larger than that size. These institutions should be divided into smaller sizes such that they can be wound up without government intervention in a dissolution process if they become insolvent.
Under this rule, no financial institution could amass aggregate liabilities in an amount greater than 5% of the then-current targeted value of the FDIC Deposit Insurance Fund (DIF) for the current year. (2) We have selected the targeted value of the DIF for several reasons. First, it is a standard that is readily identifiable; the FDIC publishes this target in the Federal Register. (3) Second, the standard is reasonably objective; the FDIC's target for the DIF is expressed as a percentage of FDIC-insured deposits. Third, the standard is flexible but reasonably protected from political influence; the FDIC is empowered by the Federal Deposit Insurance Act to use its judgment to set the target value of the DIF, taking into account any economic factors that it deems appropriate. It must, however, select a target value of not less than 1.15% of aggregate insured deposits but no greater than 1.50% of aggregate insured deposits. (4) This standard provides a practical protection against arbitrary easing as well. If the target value is increased to allow bigger banks, then all banks will have to pay higher assessments into the DIF. This has two consequences: greater resources available for possible future resolutions and higher costs for banks, the latter of which will temper those banks' fervor for growth.
This leads to our fourth reason for selecting this metric: it is linked to our ability to absorb the failure of a financial institution without jeopardizing the stability of the rest of the banking system. By way of illustration, the current targeted value for the DIF is equal to 1.15% of total insured deposits, so the bright-line limitation we propose would not allow any bank to have total liabilities in excess of 0.0575% of total deposits, or approximately $3.096 billion. (5)
We understand, of course, that the government does not always achieve its targets. For example, the current actual DIF reserve ratio is well below 1.15% and is not projected to reach the targeted level until 2018. (6) Under our proposed rule, however, the actual DIF reserve ratio is irrelevant; our analysis focuses solely on the targeted ratio, which, by statute, cannot fall below 1.15%. If our approach were adopted, Congress would have a strong incentive never to lower the minimum targeted ratio: if the ratio ever were reduced, then our rule would result in an even larger number of banks being deemed "too big" than it would under the current 1.15% target figure. And though Congress might have an incentive to raise the minimum targeted ratio in response to political pressure to allow large banks to retain their current size or to grow, any increased risks of bailouts associated with such larger banks would be offset by the larger deposit insurance premiums paid by all banks, since such premiums are tied to the targeted, not the actual, reserve ratio.
Finally, by tying the metric to the target value of the DIF and not the actual balance of the DIF, our bright-line rule does not compound a problem in times of financial crisis (that is, an unintended negative feedback loop) and avoids arguments over market accounting of DIF assets and questions of liquidity versus capital in the fund.
The bright-line rule that we are proposing would require the largest financial institutions to choose between downsizing themselves in order to comply with the size rule or acquiescing to a government-mandated breakup plan. (7) We estimate that only a small percentage of financial institutions would be affected by our rule.
The bright-line rule is simple by design. It is simple to understand. It is simple to administer and monitor. It is simple to enforce. It works prospectively and does not require large groups of lawyers, accountants, or financial engineers for implementation or compliance. It also does not rely on the hope that the government will, in the future, permit large institutions to fail, notwithstanding the fact that the government has never permitted such institutions to fail in the past. Importantly, it provides for corrective action before there is a crisis and not during or after a crisis, when political forces are at their strongest.
We are limited in our choice of contingency plans for two reasons. First, regulation, even massive regulation, has been tried and has failed. Elaborate ex ante commitments to protect some creditors--including federally sponsored deposit insurance, minimum capital requirements, activities restrictions, and government inspections--have not enabled the government to make a credible commitment to refrain from bailing out all the rest during a crisis.
Second, history is relevant. Because we have bailed out the banks in the past, people have rationally come to expect that we will bail them out in the future. Despite serious prior efforts to refrain from using taxpayer funds to bail out companies like AIG, Citigroup, and Goldman Sachs, the political fallout from the failures of these or other financial behemoths was deemed too great for bailouts to be avoided in time of crisis. Put another way, our country's established record of bailouts actually makes it far more difficult for the government to make a remotely credible commitment to stop future bailouts.
Thus, because traditional regulation does not work and because people have come to expect bailouts, the only solution to the Too Big To Fail problem is to break up the largest financial institutions to a size that is sufficiently small. This should be done so that (1) bankers, customers, and taxpayers do not expect these institutions to be bailed out; (2) voters do not want their political leaders to bail banks out, if and when they do become insolvent; and (3) banks do not have sufficient political influence to "capture" regulators or government leaders and perpetuate a false sense of economic importance. In this Feature, we articulate the guidelines that we believe should be used to break up the largest financial institutions in the economy.
The rule that we propose would limit the economic risk of future financial institution failures by severely limiting the size of banks and other financial institutions that benefit not only from explicit FDIC insurance but also from the broader set of implicit government guarantees.
In Part I of this Feature we discuss the current understandings of the concept of Too Big To Fail. Specifically, we treat the twin problems that we identify with "Big Banks." First, the government cannot credibly commit to refrain from bailing them out when they get into financial distress, as they inevitably do. Second, their size, and the certainty that they will be bailed out, creates a "follow-the-leader" mentality that magnifies the costs and the consequences of errors in judgment and analysis on the part of these institutions' managers.
Part II of this Feature analyzes two facets of the current legal regime that governs large financial institutions. First, we argue that the Too Big To Fail doctrine, which is typically analyzed...