Too-Big-To-Fail Banks

Background:

Following the financial crisis of 2007-2008, the debate over the proper way to prevent a reoccurrence of the conditions leading up the crisis has largely focused on the role of systematically important or “too-big-to-fail” banks. The Obama administration has sought to introduce legislation designed to curb the behavior of such banks, which Democrats see as a key cause of the recent financial turmoil. The controversial “Volcker rule” forms the centerpiece of Obama’s proposals and aims to stop prevent banks from becoming sufficiently large or interconnected that the collapse of one causes others to fail. Obama says the Volcker rule is “in the spirit of Glass-Steagall,” referring to the 1933 New Deal Act which prohibited commercial banks from offering brokerage and insurance services. The removal of these limitations in 1997 is widely held to be a contributing factor to the financial crisis. The administration would also disallow banks from taking part in hedge funds or other risky investment activity for their own profit.

The White House plan to cap banks’ exposure to risk and to separate investment and commercial banking would, its proponents argue, not only reduce the spread of “systematic risk” but also promote competition by increasing the market share of medium-sized banks. Former Fed Chairman Alan Greenspan recommends the dismantling of institutions deemed “ too-big-to-fail” with the goal of increasing fair competition by ending the culture that allows these banks’ to borrow cheaply because lenders believe that the government will step in to meet their obligations.

Others, however, question whether the White House’s measures would get to the heart of the problem. The New York Times points out that Lehman Brothers and Bear Stearns, two big failures of 2008, were not commercial banks, while Morgan Stanley and Goldman Sachs only became bank holding companies after the crisis began. Some argue more attention needs to be devoted to regulating the derivatives market, while still others predict that Obama’s “TARP tax” and caps on bankers’ pay will drive international banks to move their centers of operations to other, more hospitable countries and retard the recovery of lending by the banking sector.

After a year in office, competing House and Senate reform bills had been passed but nothing yet signed into law. On January 14, 2010 Obama proposed that a Financial Crisis Responsibility Fee be imposed on banks for the next ten years, or until all the money lent under TARP is recovered. He also urged banks’ executives to lower compensation and bonus levels.