What Does "Too Big to Fail" Really Cost?

If you want a better understanding of how megabanks weaken the financial system, read this recent speech by Kansas City Federal Reserve President Thomas Hoenig. It's a cogent (and fairly short) summary of the ways "too big to fail" financial firms undermine competition, stunt innovation and destabilize the economy.

This issue isn't academic. Unless companies like Bank of America (BAC), Citigroup (C) and JPMorgan Chase (JPM) are reined in, massive financial crises are certain to recur, Hoenig said:

"As a nation, we have violated the central tenants of any successful system. We have seen the formation of a powerful group of financial firms. We have inadvertently granted them implied guarantees and favors, and we have suffered the consequences....

"The fact is that Main Street will not prosper without a healthy financial system. We will not have a healthy financial system now or in the future without making fundamental changes that reverse the wrongheaded incentives, change behavior and reinforce the structure of our financial system. These changes must be made so that the largest firms no longer have the incentive to take too much risk and gain a competitive funding advantage over smaller ones. Credit must be allocated efficiently and equitably based on prospective economic value. Without these changes, this crisis will be remembered only in textbooks and then we will go through it all again."

Being "systemically important" also reduces the cost of the debt big banks issue. That's because ratings agencies factor the government's support for these companies in assessing their credit, rather than judging them chiefly on their financial condition and potential losses. As a result, TBTF firms not only get to use more debt, but also are able to borrow more cheaply than regional and community banks, which aren't backed by the feds.

What are such advantages worth? For the biggest banking companies, hundreds of billions of dollars. As of year-end 2009, the top 20 industry players held Tier 1 common equity -- a standard measure of a bank's financial strength -- equal to 5.1 percent of their total assets. Smaller institutions had average equity of 6.7 percent (see chart at bottom).

In other words, bigger banks had a smaller buffer against losses. Which is of course totally nonsensical, given the systemic risks of such large institutions going down.

Hoenig also cites one hell of a stat: If those same top 20 firms were required to hold the same equity capital levels as smaller competitors, the big banks would either need $210 billion in additional equity or have to eliminate $3 trillion worth of assets (or some combo thereof).

The Fed banker has three prescriptions for revitalizing the financial sector. First, big firms must be allowed to fail, with management, shareholders and creditors taking the fall. "Only then will creditors force these firms to operate with lower leverage," Hoenig said.

Second, financial firms must face stricter -- and better -- regulation. That means simple rules, such as establishing limits on leverage, which tends to expand during economic booms. Third, big banks should be banned from trading for their own accounts, investing in or sponsoring hedge funds, and be required to house any trading or private equity units in a separately capitalized subsidiary subject to stricter limits on leverage and asset concentration.

Sensible prescriptions. Yet Hoenig, like most members of the financial firmament, ignores the most obvious solution: Making big firms smaller. As economist Simon Johnson and others have pointed out, there's no evidence that U.S. financial firms must exceed, say, $200 billion in assets to remain globally competitive, let alone top $2 trillion, as do B of A and JPMorgan Chase.

Chart courtesy of Federal Reserve Bank of Kansas City; image from New America Foundation