The Federal Reserve Bank of Dallas recently published an essay titled Choosing the Road to Prosperity:  Why We Must End Too Big to Fail - Now" written by its Executive Vice President and Director of Research Harvey Rosenblum.  This is part two of a summary of that essay.  Part one can be found here: Is Fed Endorsing Ending to Too Big to Fail?

When financial institutions started to fail and credit froze in 2008 the Federal Reserve used the customary tools to get the economy moving again, first cutting and keeping the federal funds rate - what banks charge one another for overnight loans - close to zero.  This usually makes short-term credit available at lower rates, driving borrowing by consumers and businesses while pushing up the value of assets thus bolstering business balance sheets and consumer wealth.  Declining rates drive down the dollar making U.S. exports cheaper and more attractive overseas as long as other countries don't also drive down rates.  Second, the Fed has injected billions of dollars into the economy by purchasing long-maturity assets on a massive scale, pushing long term rates down as well.  While this reduces the burden on borrowers it punishes savers, especially those who depend on interest payments.

While growth restarted in mid-2009 it has been tenuous and fragile and stock market gains while large have been volatile.  Job growth has been disappointing with only a third of the jobs lost to the recession regained.

"The sluggish recovery has confounded monetary policy.  Much more modest Fed actions have produced much stronger results in the past.  So what's different now?"  Part of the answer is excesses that have not been wrung out of the system including falling house prices that continue to drag down the housing market.  "The Too Big to Fail (TBTF) banks remain at the epicenter of the foreclosure mess and the backlog of toxic assets standing in the way of a housing revival."

Another part of the answer is the monetary policy engine is not hitting on all cylinders.  Low federal funds rates haven't delivered a large expansion of credit because if one part of the economy isn't functioning properly it degrades the performance of the rest.  Some contributions to recovery such as asset value and wealth have been weaker than expected partly because burned investors are demanding higher-than-ever compensation for risk.

Recovery also requires well capitalized financial institutions and the machinery of monetary policy haven't worked well because of TBTF.  Many of the biggest banks still have balance sheets clogged with toxic assets while smaller banks are in much better shape either because they didn't make big bets on mortgage-backed securities, derivatives and other risky investments or if they did they have already failed. 

Injecting capital into the system as the Fed did in 2008 was necessary but one downside was a residue of distrust in the government and the banking system and an erosion of faith in American capitalism.  It showed ordinary workers and consumers a "perverse side of the system" where they see that normal rules of markets don't apply to the rich, powerful, and well connected.  TBTF violated basic tenants of a capitalistic system.  Capitalism requires:

• The freedom to succeed and the freedom to fail. Hard work and good decisions should be rewarded; more importantly, bad decisions should lead to failure.
• Government to enforce the rule of law. This requires maintaining a level playing field. TBTF undermines equal treatment, reinforcing the perception of a system tilted in favor of the rich and powerful.
• Accountability. The perception and reality is that virtually nobody has been punished for their roles in the financial crisis.

The economy faces two challenges.  The short term must focus on repairing the mechanisms so the impacts of monetary policy will travel through the economy faster and with greater force.  In the long term the country must ensure that taxpayers won't be on the hook for another massive bailout.  Both challenges require dealing with the threat posed by TBTF institutions.

The government's main response to the crisis was the Dodd-Frank Wall Street Reform and Consumer Protection Act and its effectiveness will depend on its final rules.  The lack of regulatory certainty has already undermined growth and is delaying repair of the lending and financial markets parts of the monetary policy engine. 

Policymakers can have the most impact with Dodd-Frank by requiring banks to hold more capital, "tacking on additional requirements for the big banks that pose systemic risk, hold the riskiest assets and venture into the more exotic realms of the financial landscape."  Capital cushions should be tied to size, complexity, and business lines and give TBIF institutions more skin the game and restore market discipline.  Small banks didn't ignite the regulatory crisis and shouldn't face the same burdens as big banks that follow risky business models.  TBTF banks' sheer size and their presumed guarantee of government help provided a significant edge - perhaps at least a percentage point - in the cost of raising funds.  Making them hold more capital will level the playing field among banks.

Higher capital requirements will require the biggest banks to raise equity through stock offerings or by retaining earnings through reduced dividends.  "Banks that clean up their balance sheets will have a better chance at raising new funds while laggards will find it more difficult and may further weaken and need to be broken up, their viable parts sold off to competitors.  It is important to redistribute these assets so as to enhance overall competition."

While the near-zero federal funds rate helped many banks' capital rebuilding process it could be argued that the zero interest rates are taxing savers to pay for recapitalizing those who caused the problem in the first place.

Unfortunately the sluggish recovery is a cost of the long delay in setting new standards for capital.  Given the urgent need to restore growth and a healthy job market "the guiding principles for bank capital regulation should be:  codify and clarify, quickly.  There is no statutory mandate to write hundreds of pages of regulations and hundreds more pages of commentary and interpretation.  Millions of jobs hang in the balance."

As part of its strategy to end TBTF, Dodd-Frank expanded the role of regulators and added new ones, in effect shifting responsibility from the Fed to Treasury and injecting politics into the mix.  The current remedy for insolvent institutions, i.e. FDIC resolution, works well for smaller banks but TBTF rescues over the last three decades have penalized equity holders while protecting bond holders and bank managers.  Disciplining the management of big banks, just as happens at smaller bank, would reassure a public angry with reckless behavior necessitating government assistance.

The question remains whether the new resolution procedures will work in the next crisis.  Because big banks often follow parallel practices, odds are that several will get into trouble at the same time and this might overwhelm even the most far-reaching regulator scheme.  TBTF might become TMTF - too many to fail - as happened in 2008.

A second issue is credibility.  The Implicit guarantee imputed to Fannie Mae and Freddie Mac became explicit for them and for big banks when the federal government did indeed come to their rescue.  Words on paper only matter when bankers and their creditors actually believe that Dodd-Frank puts government out of the bailout business although the new law has begun enforcing some market discipline.   "The credibility of Dodd Frank's disavowal of TBTF will remain in question until a big financial institution actually fails and the wreckage is quickly removed so the economy doesn't slow to a halt.  Nothing would do more to change the risky behavior of the industry and its creditors."

The survivors of 2008 have not changed; their corporate cultures remain based on short -term incentives of fees and bonuses, they have the lawyers and money to resist federal regulation and, their significant presence in dozens of states confers enormous political clout.

The Dallas Fed has advocated breaking up the nation's largest banks into smaller units but it won't be easy.  There are thorny issues about how to reduce the size of banks; the level of concentration deemed save will be difficult to determine, and the big financial institutions will dig in to challenge any breakups.  But a financial system composed of enough banks to ensure competition in funding businesses and households with none big enough to put the overall economy in jeopardy will give the country a better chance of navigating through future financial difficulties and this level playing field will restore faith in market capitalism.

As stated at the beginning, the problems that periodically roil the financial system are the result of complacency arising from sustained good times, greed and irresponsibility that run riot without market discipline, the exuberance that overrules common sense, and the complicity of going along with the crowd.  These are natural to humans and we cannot eliminate them, merely be alert to them.  But concentration in the financial sector is not natural but rather the result of artificial advantages including that some banks are TBTF.  Human weakness will cause market disruptions; big banks backed by government turn them into disasters.

Dodd Frank hopes to eliminate TBTF but the new law leaves the banks largely intact and they remain a danger to the financial system.  "The road to prosperity requires recapitalizing the financial system as quickly as possible.  The safer the individual banks, the safer the financial system.  The ultimate destination-an economy relatively free from financial crises-won't be reached until we have the fortitude to break up the giant banks."