In a post I wrote about a year ago, I predicted, as did many others, that financial reform would likely be coming for those in the banking industry.  The regulatory debate is now in full swing and it is encouraging to see the issue of Too Big To Fail (TBTF) rising to the forefront as an important issue to be addressed.

I have to agree with those who believe that the TBTF inherent policy is the antithesis to capitalism.  It has been shown time and again to allow firms to take on reckless amounts of risk.  These institutions then take advantage of the upside of a cycle by rewarding their success with large salaries and bonuses which during good economic times do not receive as much public condemnation.  Then, when the bets go bad, the firm, because of its large size receives a bail-out from the taxpayers to prevent complete meltdown.  We saw this most notably with Long Term Capital Management in the 90’s and again in 2007 with the mortgage crisis and as long as the TBTF policy is in place this type of behavior will continue.

Regulatory discussions have focused on this issue of TBTF but there is also a push for resolution authority which would allow the government to lead firms through a cleaner bankruptcy.  Resolution authority to me seems like a way to continue business as usual and stands out as a reactionary ad-hoc fix instead of a preventive measure.  We need policies in place that will ensure an environment which will have the least probability of boom-and-bust.  One of the congressman poignantly addressed this issue during a debate when he posed the question whether anyone knew a well capitalized, well regulated, well managed bank to fail.

One of the reforms being discussed is to limit the size of banks.  A number that I remember being put foreword is $100 billion dollars.  This would be the size that would not be TBTF.  It has also been questioned how much is actually gained in efficiency for banks larger than this size.  One problem asserted about this cap is that it does not address the issue of counter party risk.  From my understanding a scenario could still result in which all banks were within the $100 billion limit but because of large amounts of counter party risk a massive meltdown would still take effect.  However, it seems that if banks became better capitalized in conjunction with cap limits the chain reaction could be cut short.

The scope of the TBTF issue is huge and delving into every aspect would fill a book, but as I said at the beginning of this article it is encouraging to see it being addressed.  Regulators however still can expect to face many roadblocks ahead.  Reforms would have many logistical problems such as aligning the regulation with the global structure of bank regulation.  Capping the bank size would mean breaking up colossal banks and reforms would  have to be wide reaching so that all financial firms regardless of legal make-up would be effected equally.  We then would need to be vigilant so that new rules are enforced and of course ensure that new regulation won’t strip away the competitiveness of the US banking industry.

I expect to see increasing coverage of TBTF in the future and I encourage those who still want more information on this topic to watch the video posted further up or visit The Baseline Scenario, where you will find numerous posts regarding this issue.