Kevin Warsh: “No Firm Should Be Too Big To Fail”

The debate over Ben Bernanke’s reappointment, and his approach to the financial system, may after all have had some impact.  In a speech yesterday, Kevin Warsh – the Federal Reserve Board Governor who liaises between Ben Bernanke and financial markets – signaled a major change in Fed thinking regarding “too big to fail”.
Warsh was much blunter than we have heard from the Fed in a long while: “Moral hazard in the financial system is higher than any of us should countenance”; “eradicating the too-big-to-fail problem should be the predominant policy goal”; and “in the new regime, no firm should be too big to fail.”
At some level, Warsh and his colleagues are finally learning the main lesson of 2008-09.
“We need a system in which insolvent firms fail. Market discipline only works if governments can demonstrably and credibly commit to allow firms to fail. This system isn’t just about giving government officials better options on Sunday nights. It is about making sure that market discipline is operative in the prior months and years to avoid altogether the proverbial Sunday night judgments.”
But there is still a major problem in the Fed’s thinking.
Warsh is right that market dynamics could be helpful.
“Market entry and market exit can be a more effective means of developing a stronger, more resilient financial system. The too-big-to-fail problem could be mitigated if smaller, dynamic firms seized market share from less nimble incumbents”
And he is completely on target with the respect to the principle at stake.
“Competition is undermined when a privileged class of financial firms has the implicit support of the government. No firm ought to be entitled to favored consideration by regulators or government policy. No rating agency. No mortgage finance entity. No dealer or underwriter. And no bank. The tempting top-down approach to level the playing field is to bully or co-opt our largest, most interconnected firms. In my view, however, robust competition from the bottom-up is the better way forward.”
But he stops short of calling for a restriction on the size of our largest banks.  Without that, it is very hard to see how his competitive mechanisms will work.
The current low relative cost of credit for mega-banks – significantly below what is paid by smaller banks that can fail (i.e., banks that can realistically be taken over through a FDIC intervention) – constitutes a form of unfair subsidy that enables the biggest banks to become even larger.
How exactly does Mr. Warsh plan to back away from this situation?  He implies we should promise not to help huge banks when they get into trouble – but surely he knows this would not be credible.
He also makes some vague statement about helping smaller banks, but how does that work when the big banks now dominate the markets at the center of our financial system?
While the US financial system has a long tradition of functioning well with a relatively large number of banks and other intermediaries, in recent years it has become transformed – through years of regulatory and antitrust neglect – into a highly concentrated system for key products.  The big four have 1/2 of the market for mortgages and 2/3 of the market for credit cards. Five banks have over 95% of the market for over-the-counter derivatives. Three U.S. banks have over 40% of the global market for stock underwriting.  This degree of market power is dangerous in many ways.
As Mr. Warsh now realizes, these large banks are widely perceived – including by their own management, creditors, and government officials – as too big to fail.  The executives who run these banks obviously have an obligation to make money for their shareholders.  The best way to do this is to take risks that pay off when times are good and that result in bailouts – creating huge costs for taxpayers and all citizens – when times are bad.
This incentive system distorts market outcomes, encourages reckless risk-taking, and will lead to serious trouble.   While reducing bank size is not a panacea and should be combined with other key measures that are not yet on the table – including a big increase in capital requirements – finding ways to effectively reduce and then limit the size of our largest banks is a necessary condition for a safer financial system.
The Fed is apparently, at last, moving the right direction on the issue of “too big to fail”.  But how long will it take to get there?
By Simon Johnson