Barney Frank, a Democrat, represented Massachusetts in the House of Representatives from 1981 to 2013 and was chairman of the House Financial Services Committee from 2007 to 2011.
There is a fundamental weakness in the position of those who insist that the only way to deal with financial institutions that are “too big to fail” is to break them up: their acknowledgment that the central question of how big is “too big” is too hard to answer. This is rarely made explicit, but it is universal. Across the ideological range from Sen. Bernie Sanders (I-Vt.) to Neel Kashkari, president of the Minneapolis branch of the Federal Reserve, the “break ’em up” advocates scrupulously avoid suggesting any size beyond which banks must not be allowed to exist.
The reason for this glaring omission — which renders their argument of little practical use for makers of actual decisions — is clear, once the focus is on the meaning of “too big to fail,” as opposed to its invocation as a general expression of distrust of banks. The issue is how to avoid a situation in which an institution has incurred so much debt that its inability to pay threatens the stability of the financial system. In other words, how do we prevent a repetition of the damage caused by the collapse of Lehman Brothers in 2008? Therein lies their dilemma.
The Wall Street reform bill that I co-authored, commonly known as the Dodd-Frank Act, takes a three-step approach:
First, it includes measures to reduce the riskiness of financial activities — for example, prohibition of the issuance of mortgage loans to people unlikely to repay and a requirement that securitizers of bundled loans retain a portion of the risk.
Second, it mandates significant increases in the ability to repay debts, both for institutions as a whole and for particular transactions, most notably those involving derivatives. AIG’s dubiously impressive feat of incurring $170 billion in credit-default-swap obligations that not only could it not pay but also of which it was not able even to keep track will remain a record in recklessness.
The best defense of these provisions comes from Steve Eisman, featured prominently in Michael Lewis’s book “The Big Short” for being one of the first to understand what was going wrong: “It is simply a fact that the United States financial system is much less risky than it was before. That does not mean that losses cannot occur, but United States banks are in much better shape to withstand them.”
Better, but admittedly not absolutely. The restrictions on leverage do not guarantee that no institution will get in over its head, although they do mean that the level of excess indebtedness in such cases is almost certain to be much lower than it otherwise would be.
Consequently, the third part of Dodd-Frank allows large entities to fail without causing serious collateral damage. When the next Lehman Brothers or AIG cannot pay its debts, federal officials are legally instructed to begin the process of dissolving it; to borrow money from the treasury to pay, not all of its debts as the law required in 2008, but only as much as is needed to avoid threatening the system; and then, in a binding mandate, to recover any federal funds expended through assessments levied on all financial institutions with more than $50 billion in assets.
Some of those who insist on reducing firms to a level incapable of incurring Lehman-size indebtedness describe this scheme as a protection for large institutions, reassuring their potential counterparties that the government will back them up. Reality refutes this.
The law automatically puts several large banks and securities firms into this category of enhanced supervision by the Financial Stability Oversight Council. Others could be included either by a decision of the FSOC or by growth to the $50 billion asset threshold. Every institution faced with the possibility of inclusion is fighting as hard as it can to avoid it. It turns out that the tighter regulation, higher capital standards and the possibility of dissolution are less attractive than the law’s critics would have us believe.
This brings me back to the dilemma that explains why those who dismiss the law’s approach in favor of an across-the-board downsizing refuse to specify the appropriate maximum level.
Once again, the culprit is Lehman Brothers. Given that it was this firm that touched off the crisis in 2008, making sure that no entity is large enough so that its failure would be seriously destabilizing means imposing a cap at some level smaller than Lehman Brothers was at that time. Lehman’s asset size was estimated at $639 billion, so allowing — perhaps dangerously — firms to be 95 percent Lehman’s size means no bank or securities firm going forward could be larger than $607 billion.
In light of the enormous disruption the system would suffer in the process of getting our largest institutions down to that level, and the serious disadvantage it would mean for American businesses in a global economy — both for those providing financing and those needing it — I am not surprised that the vigor with which some insist that only breaking up the banks can defuse the “too big to fail” bomb vastly exceeds their willingness to tell us even approximately how low we must go.