Wednesday, March 21, 2012

The Dallas Fed and Too Big To Fail

The Federal Reserve Bank of Dallas recently released its 2011 Annual Report.  I'd like to focus on one part of the report, the opening Letter from the President of the Dallas FRB, Richard W. Fisher.  Mr. Fisher is well known as a dissenting voice among Federal Reserve Bank Presidents, a fact that will become very apparent as you read the passages that I have selected from his single page musings.

Mr. Fisher sets the tone in the first sentence of his letter:

If you are running one of the “too-big- to-fail” (TBTF) banks—alternatively known as “systemically important financial institutions,” or SIFIs—I doubt you are going to like what you read in this annual report essay written by Harvey Rosenblum, the head of the Dallas Fed’s Research Department, a highly regarded Federal Reserve veteran of 40 years and the former president of the National Association for Business Economics.”

In case you'd forgotten, it was these so-called indispensible banks and financial institutions that very nearly drove the American and world economy into a Depression.  It was because of this that Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act.  This Federal law created the Financial Stability Oversight Council (FSOC) to prevent such a bank-led collapse in the future by reducing America's dependence on overly large banks that cannot be allowed to fail for fear that the economy would implode.  The Act will basically create a new banking regulatory environment that enforces both accountability and transparency at the same time as consumers are protected from risky actions by the banking industry.  In a nutshell, the Dodd-Frank Act is a desperate attempt to put an end to the issues related to having financial institutions that are too big to fail for once and for all.

While the intentions of Dodd-Frank were good, Mr. Fisher notes that there has been an unintended consequence of Dodd-Frank.  Imagine that, an unintended consequence of a legislative act!  The Dallas FRB is concerned that Dodd-Frank has actually increased concentration in the banking industry.  For your illumination, here is a pie chart showing how the concentration in the U.S. banking industry has increased over the forty year period from 1970 to 2010:

In 1970, the top five banks controlled only 17 percent of the country's assets; by 2010, the top five banks controlled 52 percent of assets.  In Mr. Fisher's letter, he notes that the top 10 banks now control 61 percent of commercial banking assets, up from only 26 percent 20 years ago.  To put the size of these assets into perspective, the assets of the top 10 banks alone are equal to one half of the nation's GDP.  On top of the concentration of assets, the number of smaller institutions has dropped markedly from 12,500 in 1970 to 5,700 in 2010.  These smaller institutions which were generally well managed prior to and throughout the crisis, controlled 46 percent of banking assets in 1970; this fell to a meagre 16 percent in 2010.  Basically, this data is telling us that not only have banking assets been concentrated in the hands of fewer bigger banks but that the assets controlled by fewer smaller banks have decreased by a disproportionately large amount.

Mr. Fisher goes on to note:

"In addition to remaining a lingering threat to financial stability, these megabanks signifi- cantly hamper the Federal Reserve’s ability to properly conduct monetary policy. They were a primary culprit in magnifying the financial crisis, and their presence continues to play an important role in prolonging our economic malaise.”

There are good reasons why this recovery has remained frustratingly slow compared with periods following previous recessions, and I believe it has very little to do with the Federal Reserve. Since the onset of the Great Recession, we have undertaken a number of initiatives— some orthodox, some not—to revive and kick-start the economy. As I like to say, we’ve filled the tank with plenty of cheap, high-octane gasoline. But as any mechanic can tell you, it takes more than just gas to propel a car.

The lackluster nature of the recovery is certainly the byproduct of the debt-infused boom that preceded the Great Recession, as is the excessive uncertainty surrounding the actions—or rather, inactions—of our fiscal authorities in Washington. But to borrow an analogy Rosenblum crafted, if there is sludge on the crankshaft—in the form of losses and bad loans on the balance sheets of the TBTF banks—then the bank-capital linkage that greases the engine of monetary policy does not function properly to drive the real economy. No amount of liquidity provided by the Federal Reserve can change this."

This is a hard point to argue against.  From the FRED website, here is a look at the growth of M1:

Here is a look at the growth in M2:

M1 has grown by $850 billion or 62 percent since the beginning of 2008 and M2 has grown by $2.4 trillion or 32 percent.  The growth in both M1 and M2 is unprecedented in recent history and should have provided ample (some would say way too much) liquidity.  Apparently, the Fed is doing what it has done in the past, dumping vast volumes of cheap money into the economy to prod reluctant consumers and corporations to borrow.  As I’ve noted in previous postings, it simply has not worked this time.

So, what's the problem?  Those same TBTF banks that taxpayers bailed out still hold a massive quantity of toxic assets related to their "sins of the past" on their balance sheets.  As well, the seemingly never-ending collapse in the real estate market bubble has made reluctant borrowers out of consumers and reluctant lenders out of bankers.  As well, with Dodd-Frank being perpetually in limbo, banks both large and small are uncertain about their futures.

The issue of the TBTF banks is still problematic.  The author of the accompanying "Choosing the Road to Prosperity" report, Harvey Rosenblum, notes that the situation in 2008 did actually cause the failure of commercial banks holding nearly one-third of the assets in the banking system but that extraordinary intervention by the government (read, taxpayers) kept the banking system on life support.  Dodd-Frank will prevent those actions in the future.   He notes that the very concept of TBTF is contrary to the foundations of capitalism; it creates an unequal playing field where certain institutions are granted the right to make risky business decisions and ignore the risk of failure whereas smaller institutions are forced to make what may appear to be less rewarding business decisions simply because there is no rescue program in place since the economy won't miss them if they should disappear.  This completely removes the freedom of businesses to both succeed and fail based on their decisions.  In other words, the concept of moral hazard.

Here's what Mr. Fisher has to say in closing:

"The TBTF institutions that amplified and prolonged the recent financial crisis remain a hindrance to full economic recovery and to the very ideal of American capitalism. It is imperative that we end TBTF. In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response."

With the United States government facing an almost insurmountable debt mountain, the Federal Reserve having a massively bloated balance sheet and the TBTF banks still carrying untold trillions of dollars worth of toxic assets on their books, we may find out sooner rather than later how important Mr. Fisher's advice is.


  1. While I agree that it's better not to have TBTF, it's frustrating that no one is proposing how to downsize the banks out of the TBTF size. It's an obvious question that's floating around without anyone answering it. Are the "living wills" showing how to dissect a large bank actually available and up to the task? I hope so, but I'd like something more concrete than 'hope.'

  2. US Banking concentration is a problem. We broke up ATT and the economy was the better for it. We should do the same with the biggest 5 banks.

  3. Protecting the status quo is not an option. Yes, Audit Committee oversight has improved significantly since Sarbanes-Oxley Act of 2002. So let's adopt a model of continuous improvement and learn from our mistakes. Since the man created financial crisis of 2008 it is obvious to the independent, skeptical, objective, and professional observers that it is time to be blunt with the accounting industry elite and global financial institutions.

    What I'd like to see discussed is the reinstatement of Glass-Steagall like segregation of financial responsibilities in addition to mandatory auditor rotation. The collective goal should be to break up the too big to fail entities into risk manageable entities and increase competition among the global accounting firms. We need to reduce or eliminate the built-in conflicts of interest we allowed by allowing Audit Committees oversight over insurance, brokerages, commercial lending, and investment banking. Segregation of financial responsibilities is a time tested and proven method to prevent and detect fraud because it makes it more difficult to collude. The USA accounting firms have a terrible record of preventing and detecting fraud since the repeal of Glass-Steagall.

    What we have today are too close for comfort relationships between global audit firms and interconnected and systemically important global financial institutions.

    To put it bluntly - the plan to consolidate wealth and power was a plan too big to fail, until of course, it failed miserably in 2008. It is past time to return to competitive capitalism by reorganizing back into a system that did not fail us before it was dismantled beginning in 1998.

    Competition is good. Competition works. Competition will generate a higher quality product at a lower cost every time. Anything to increase competition within the profession will take us on a path toward restoring the credibility of the profession. It is not a secret. The credibility of the accounting profession has been declining steadily throughout the world.