Throughout the 2008 crisis, governments around the world came to the aid of the ailing financial sector in various ways. Bottom line is that the banking industry received massive public support with some banks receiving government funding or becoming nationalized.
However, scarce capital relative to bank risk increased the depth of the financial crisis and the cost of government involvement. Hence, reforms passed under the Dodd-Frank Act are designed to reduce the probability of too-big-to-fail (TBTF) bank failure by increasing minimum capital levels. While that makes sense in theory, is this working in practice? In other words, should excessively large banks be prevented from failing for the public good?
Big Banks: Too Big?
The Dodd-Frank Act was designed to avert a repeat of the 2008 crisis and prevent governments from having to rescue big banks. However, the largest banks in the U.S. are bigger today than they were prior to the meltdown. Five banks (JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs) held more than $ 8.5 trillion in assets at the end of 2011 compared to $6 trillion in 2006.
There is a legitimate concern that Dodd-Frank Act legislation has not solved the problem of putting taxpayer money on the hook for TBTF banks.
The Dodd - Frank Act Legislation
Title II of the Dodd-Frank Act created the Orderly Liquidation Authority. Under this special process, the Federal Deposit Insurance Corporation (FDIC) has the power to bail out a large financial institution under crisis.
To minimize widespread consequences, the FDIC will allocate a selected portion of the firm's asset and liabilities to a new institution, allowing some creditors to receive higher payments than under a bankruptcy or a bailout.
However, bailing out some creditors can have a negative effect that actually increases the chance of bank failure. Generally, creditors administer risk undertaken by a financial firm by cutting their exposure. A bailout will put them in a comfort zone and gives them less reason to be cautious.
Moreover, the shareholders in a failing bank, unlike creditors bailed out under Dodd-Frank, will not be protected, causing uncertainty throughout the bailout process.
The Steps Ahead
Industry experts are proposing various methods to ensure the stability of the industry and address the problem of TBTF.
Restructure big banks: According to Richard Fisher, president of Federal Reserve Bank of Dallas, the corporate entities of large financial institutions should be reorganized to ensure a speedy bankruptcy process. Smaller banking entities that are more in line with the 99.8 percent of banks in the U.S. are easier to regulate.
Expose big bank assets: U.S. accounting principles allow banks to cover up derivatives trading: U.S. banks hide about $5 trillion in derivatives assets in their balance sheets. Industry pundits believe U.S. banks should adopt International Financial Reporting Standards (IFRS) t0 reveal assets held in derivatives. Moreover, following IFRS guidelines will force banks to disclose their true book to market ratios. True book-to-market-value ratios will be less than 1.0, in a sense restructuring all big banks into small operational units.
Expose the use of special purpose entities: The special purpose entity--an accounting device engaged by Enron to hide its debts--is finding its place again. Wells Fargo's "variable interest entities" had total assets of about $1.5 trillion by the end of 2011 as cited by Forbes. Industry experts demand transparency in these activities.
Examine banks' role in the economy: The key function of banks is to increase opportunities and condense the risk for citizens and enterprises. The monetary help banks receive from the Federal Reserve has no positive impact on the economy. Banks are doing well and getting bigger, but the real economy is struggling. Efforts should be made to monitor bank activities devoted to uplifting the economy.
Expose "bad profits" practices: In their quest for profits, a few banks began practicing what is commonly known as "bad profit practice" such as rigging LIBOR rates, mistreatment of foreclosures, tax dodging activities, and money laundering. New regulations designed by the Federal Reserve and other governing bodies should make industry reporting more transparent and make it easier to keep a close eye on such practices and thus, track the impact of bank practices on the economy.
The Dodd-Frank Act includes procedures to wind down troubled institutions. But in order for Dodd-Frank to succeed, regulators must take stern steps against large, politically interconnected, and powerful companies. The Federal Reserve must encourage the financial sector to provide transparency. If banks fulfill the purpose of their existence in the economy, then profits will follow.