Thursday, May 28, 2015

The Story We've Told Ourselves About "Too Big to Fail" is False

There is a story we've told ourselves about what caused the Great Recession of 2008. Here's how it goes:

"Too big to fail" banks engaged in criminal and unethical activities that led to their near collapse, so government (i.e., taxpayers) had to bail them out in order to stop another Great Depression.

With that as the story, a lot of "populist" Democrats suggest that the solution is to break up the "too big to fail" banks in order to prevent us from ever having to bail them out again. Of course that story is combined with the fact of growing income inequality and so many assume that taking the big banks down a peg or two will mitigate the gap.

Finally, blaming the Great Recession on the big banks provides us with a villain to blame for all the pain and suffering of millions who lost jobs, homes, retirement savings, etc.

Given my distrust of conventional wisdom, I've always thought that it is important to do a reality check on this kind of narrative in order to determine if it has any bearing on the truth or if it is simply a liberal version of what Stephen Colbert called "truthiness." Thanks to some great analysis by Michael Grunwald, it's clear that this story we've told ourselves is mostly the latter.
Breaking up the banks is one of those ideas that sound great in theory but less so in reality, a no-brainer until you run it through your brain. It’s not that size doesn’t matter at all, but the debate over size has been absurdly one-sided, ignoring the benefits of bigness, the potential costs of breakups, and what’s already been done to address the too-big-to-fail problem.
Here are some facts to run through your brain:

It wasn't the collapse (or near-collapse) of "too big to fail" that triggered the Great Recession.
Bear Stearns wasn’t even one of the fifteen largest U.S. financial institutions in March 2008, when the Fed had to engineer a massive rescue to prevent it from collapsing and dragging down the global economy with it. Lehman Brothers wasn’t even in America’s top ten when its failure did trigger a global meltdown that September.
"Too big to fail" banks got bigger because they were able to absorb the smaller firms that were failing.
If JP Morgan hadn’t been big and strong enough to absorb the hemorrhaging balance sheets of Bear Stearns and Washington Mutual, we might well have endured a depression. Ditto if Wells Fargo hadn’t been big and strong enough to let Wachovia collapse into its arms. The world is also lucky Bank of America was big and (arguably) dumb enough to salvage Countrywide and Merrill Lynch from the jaws of death.
"Too big to fail" banks were not the only ones engaged in risky behavior and also not the only ones who got bailed out by the government.
And while mega-rescues for mega-banks dominated the headlines, over 900 community banks and regional banks received bailouts through the Troubled Asset Relief Program as well. The government also guaranteed unsecured bank debt, money market funds, and deposits of up to $250,000, which amounted to an even more generous bailout of Main Street banks.
Glass-Steagall wouldn't have helped.
Bear, Lehman, Merrill, Fannie Mae, Freddie Mac, AIG and the other firms at the heart of the crisis were totally unaffected by Glass-Steagall.
What led to the 2008 collapse was not size - but risky bets.
...the main cause of hellacious crises is not overlarge banks. It’s overleveraged banks that make risky bets with borrowed money. Before the panic of 2008, the financial system had a risk problem, not a size problem.
Beware of unintended consequences.
Breaking up the big banks would inject tremendous turmoil into a confidence-based industry where turmoil can have far-reaching unintended consequences.
Grunwald points out that overall, Dodd-Frank is working by raising the capital requirements for big banks in order to protect against the risks. And then he goes on to talk about ways that the current regulations could be strengthened. But ultimately, vigilance is what will be required.
Risk has a way of migrating to the path of least resistance...What’s safe to predict is that risk won’t go away. The goal should be to monitor and manage it, not to eradicate it. Financial reformers often make grand pronouncements about how this or that reform will eliminate the risk of meltdowns and bailouts, but those risks will remain as long as human beings are susceptible to manias like the one that inflated the credit bubble before the crisis and panics like the one that nearly shredded the system during the crisis—in other words, as long as human beings are human.


  1. I've thought for a while that bigness is a secondary problem in this case: bigness carries its own serious risks, but the bigger problem was poor regulation and the wild speculation that enabled. That's what needed to be addressed first.

  2. Michael Grunwald wrote a book about how profoundly progressive President Obama's stimulus was:

  3. Dean Baker would be disappointed that you didn't mention the housing bubble anywhere in this post. ;-)

    Seriously, the underlying cause of the crash was the housing bubble. The failure of Lehman, TBTF, etc., etc., was tied up with that, but it was secondary.

    E.g. (from 2005).


  4. This comment has been removed by the author.

  5. I believe the word you are grasping for to explain the crash is "fraud".
    Lots and lots of fraud perpetrated by bankers and Wall Street.
    Fun fact: Fraud is considered a felony punishable by prison time when perpetrated by the poor and minorities.

  6. There are a couple dots you are failing to connect, motivated (I speculate) by your desire to debunk the CW.

    Why do banks take risks? That's their job. What kinds of things increase the risks banks take:
    1. Being too big to fail means that the stockholders (ie, the executives) will not suffer if the risks go bad.
    2. The housing bubble had many causes, but let's call it the securitization of sub-prime loans which separated lenders from the risk of default. Why did this situation exist? At least partially because big banks have big power and caused the lack of regulation. Community banks did not fuel the bubble.

  7. Actually, the more I read of Grunwald's piece, the angrier I get.

    His source for info about Community Banks? Former FDIC chair Shelia Behr? No, Congressman Brad (female staff beware) Sherman.

    And this sentence is simply plagiarized from Phil Graham circa 1998:
    "Unilaterally enforcing size limits on domestic banks would put the U.S. at a real competitive disadvantage in financial services."

    A. What would it mean if our banks were at a competitive disadvantage? Well, that was the situation until Graham, Greenspan and Clinton repealed Glass Stegall. In other words: the best engine of expanding middle class well being that Earth has ever seen.
    B. Says who?

  8. Wait... That's not even close to the worst of it. What was the problem with the massively under-regulated shadow banking sector? Too much regulation is what caused the lack of regulation. As absurd as it sounds, that's Grunwald's actual claim.

    "In retrospect, America’s pre-crisis regulations for commercial banks like JP Morgan and Citi were clearly too weak. But they were strong enough to drive trillions of dollars worth of risky assets into the less regulated “shadow banking system”—investment banks like Bear and Lehman, government-sponsored enterprises like Fannie and Freddie, and insurers like AIG, not to mention off-balance-sheet vehicles that commercial banks like Citi used to dodge their regulatory constraints."

  9. Deregulation is the culprit and big banks lobbied hard to get it:

  10. Nancy, the biggest banks didn't fail because they got bailed out. The numbers below range from 2 to 25 BILLION (echos of Carl Sagan here)

    10/28/2008 Wells Fargo & Co. San Francisco Calif. $25,000,000,000
    10/28/2008 State Street Corp. Boston Mass. $2,000,000,000
    10/28/2008 Bank of America Corp.1 Charlotte N.C. $15,000,000,000
    10/28/2008 JPMorgan Chase & Co. New York N.Y. $25,000,000,000
    10/28/2008 Citigroup Inc. New York N.Y. $25,000,000,000
    10/28/2008 Morgan Stanley New York N.Y. $10,000,000,000
    10/28/2008 Goldman Sachs Group Inc. New York N.Y. $10,000,000,000

    And note below, the reason other banks could buy up the failed ones was because the government guaranteed to protect them from losses - see below:
    Financial rescue plan aimed at restoring liquidity to the financial markets.
    Program Committed Invested Description
    Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility Unlimited $0 million Financing to banks for purchases of three-month asset-backed commercial paper from money market mutual funds to promote money market liquidity.

    Bank of America loan-loss backstop $97 billion $0 Funds set aside to insure against bank's potential losses from Merrill Lynch merger.

    Bear Stearns bailout $29 billion $26.3 billion Program to guarantee potential losses on Bear Stearns' portfolio; smoothed the way for JPMorgan Chase to buy the failed investment bank. JPMorgan scoops up Bear

    Citigroup loan-loss backstop $220.4 billion $0 Funds set aside to insure against bank's potential losses from mortgage-backed securities investments.

    Commercial Paper Funding Facility $1.8 trillion $14.3 billion Purchases of short-term corporate debt aimed at boosting the struggling market and providing critical three-month financing to businesses.

    Foreign exchange dollar swaps Unlimited $29.1 billion Exchange of dollars to 13 foreign central banks for collateral. Aim is to provide liquidity to foreign financial institutions.

    Fed pumps out more dollars

    GSE debt purchases $200 billion $149.7 billion Program to buy debt issued by Fannie Mae and Freddie Mac. Aim is to reduce rates on home loans.

    GSE mortgage-backed securities purchases $1.25 trillion $775.6 billion Program to buy mortgage-backed securities held by Fannie Mae and Freddie Mac. Aim is to reduce rates on home loans.

    Money Market Investor Funding Facility $600 billion $0 Programs to help money market funds by lending to funds directly.
    Primary Dealer Credit Facility n/a $0 Long-time lending facility for commercial banks that was opened to investment banks for first time in March 2008.
    Term Asset-backed securities Loan Facility $1 trillion $43.8 billion Program to buy consumer loan-backed securities. Aim is to revive the securitization market for consumer loans like credit cards and auto loans.

    To TALF, or not to TALF

    Term Auction Facility $500 billion $109.5 billion Lending program that allows commercial banks to unload hard-to-sell assets, including mortgage-backed securities: Fed takes assets as collateral and banks get cash.

    Why bailout might not work

    Term Securities Lending Facility $250 billion $0 billion Federal Reserve facility that loans Treasurys to banks against hard-to-sell collateral like mortgage-backed securities.
    U.S. government bond purchases $300 billion $295.3 billion Federal Reserve will buy up to $300 billion of U.S. debt to support Treasury market and help keep interest rates down for consumer loans.
    Fed total $6.4 trillion $1.5 trillion