Too Big to Fail: Some Questions for the House Financial Services Committee

Tomorrow, the House Finance Committee, chaired by Representative Jeb Hensarling (R–TX), is holding a hearing on one of the most damaging legacies of the 2008 financial crisis: the “too big to fail” doctrine.

Simply put, the doctrine holds that some firms are so essential to the functioning of the U.S. financial system—and their sudden failure so disruptive to the economy—that policymakers must keep them from failing, bailing them out if necessary.

Four witnesses are scheduled to discuss the issue tomorrow: Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation (FDIC); Richard Fisher, president of the Federal Reserve Bank of Dallas; Jeffrey Lacker, president of the Federal Reserve Bank of Richmond; and Sheila Bair, formerly chair of the FDIC. There are a number of key questions that Members should ask during this hearing:

• What is the current state of too-big-to-fail? Some of the witnesses have argued that too big to fail is no longer in place. But is that credible? How would regulators today react to the failure of a big financial institution? Does the recent designation of AIG, Prudential Insurance, and GE Capital as “systematically important financial institutions” implicitly extend guarantees to them?
• What is the cost of too-big-to-fail? Bloomberg has estimated that too-big-to-fail provides a hidden subsidy worth $83 billion to big financial institutions. Is that number accurate? Who bears the cost—taxpayers, other financial institutions, the taxpayer? How has the implied guarantee affected smaller competitors?
• Is breaking up big banks the answer? How would regulators determine the “proper” size for a financial institution? Is size really the issue? What about interconnectedness? A forced breakup could result in less efficient and less internationally competitive banking system,, without solving the dilemma of too-big-to-fail.
• Would higher capital standards solve the problem? What are the costs of higher capital requirements? What would be the effect on lending? How high is high enough? Should capital standards be set by Congress? A politically determined capital standard would likely reflect political more than economic concerns.
• Should the goal be to prevent failures of the largest financial institutions? Is it preferable to establish a mechanism for winding down large financial institutions without undue harm to the economy? This may be a case where failure should be an option.
• Does the orderly liquidation authority (OLA) provide such a process? How is regulator discretion under OLA limited? What is the potential for abuse? As written, the OLA procedure contained in the Dodd–Frank regulation law gives regulators nearly unchecked power, with few legal limits and little opportunity for appeal.
• Is the bankruptcy process an answer? Are large financial bankruptcies more complex than bankruptcies of other firms? A modified form of bankruptcy could assure that property rights and the rule of law are protected while providing a mechanism for a swift resolution of the troubled firm.

Too-big-to-fail is perhaps the most important—and most vexing—problem facing financial regulators today. There are no easy answers, but the cost to taxpayers and the financial marketplace is simply too high to ignore. Tomorrow’s hearing provides an opportunity for policymakers to sort out the facts and alternatives, and begin to take the first steps toward a real solution.