Thursday, May 2, 2013

Too Big to Fail needs to be sorted out

The Dodd-Frank Act was suppose to eliminate the problem of Too Big to Fail.  It was suppose to achieve this wonderful result through the combination of complex regulations, regulatory oversight and Congress promising not to authorize a bailout should there ever be another systemic financial crisis.

Clearly, market participants, like investors, realize that this combination is not up to the task of eliminating the TBTF problem.

Now, Brown-Vitter is suppose to eliminate the problem of Too Big to Fail.  It is suppose to do this by making banks over $500 billion hold equity capital equal to 15% of their total on balance sheet assets plus off balance sheet exposures.

There are two ways that B-V is suppose to convince market participants, like investors, that the problem of TBTF has been eliminated.

First, the high equity level is suppose to act as an incentive so that the TBTF banks split themselves into smaller banks (21 if all the TBTF divide themselves up) that presumably can fail and be resolved by the FDIC.

Second, if a TBTF doesn't break itself up, the higher equity level presumably can absorb the losses when the FDIC steps in to resolve it.

While your humble blogger believes that B-V is a step in the right direction, it is not clear that it eliminates the problem of TBTF as it does not address the issue of interconnectedness in the financial system.

Is Congress really not going to step in with a bailout if 3 of the smaller banks fail and threaten to trigger a systemic financial collapse?

Regular readers know there is a far simpler and more direct approach to ending the TBTF problem.  Simply require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

History shows that when banks provide this level of transparency, they tend to maintain the B-V 15% equity ratio.

History also shows that when investors have the information they need to independently assess the risk of an investment, they tend to limit their exposures to what they can afford to lose.  Banks are no different and this would end the issue of interconnectedness.

Finally, history shows that when banks have to disclose their exposure details, they stop taking proprietary bets (see Jamie Dimon's efforts to withhold information on London Whale trade for fear market trade against JPM).

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