Stephen G. Cecchetti and Kermit L. Schoenholtz write,
Imagine the following simple approach (like that of Acharya et al). Let the capital structure of a bank’s long-term liabilities be clearly stated and then honored if and when necessary. That is, think of the bank as having a hierarchy of long-term debt ranging from the most senior (call it tranche A) to the most subordinated (tranche Z for zombie!). Whenever a bank’s capital position is deficient – say, because the market value of its equity sinks below a threshold ratio to its book assets – the resolution authority automatically makes some of the debt into new equity, starting with the Z tranche and then climbing up the alphabet until there is sufficient capital to return the bank above the regulatory minimum. Provided that there is sufficient long-term debt to absorb the losses, the concern remains a going one. (The resolution authority could still replace management and shut down risky activities in an effort to prevent a serial failure.)
Pointer from Mark Thoma. This is an alternative to the idea of divesting the firm’s assets according to a “living will.” The authors write,
But let’s not overstate the attractiveness or simplicity of the phoenix plan. No scheme can eliminate policy discretion, as crises often lead governments to change the rules on the fly (think of the 2008 TARP legislation that followed the failure of Lehman).
The way I read this, we really cannot get back to the rule of law if we have too-big-to-fail banks. That is what I will be arguing in two weeks. These institutions will be given special treatment, particularly in a crisis. In 2008, AIG was eviscerated in order to provide a liquidity injection to Goldman Sachs, Deutsche Bank, and others. Does anyone think that the decisions would have come out the same if the Treasury Secretary had been a proud alumnus of AIG rather than of Goldman Sachs?
Some of my other thoughts for the panel.
1. Suppose that we were to limit any financial institution to $250 billion in liabilities that are not backed by capital. Currently, the largest banks in this country seem to have over $1 trillion in liabilities.
2. What can you not do with a $250 billion portfolio? What would such a bank be precluded from doing, other than buying another huge bank?
3. I think it is pretty hard to know for certain the extent of economies of scale and scope in banking. However, my intuition is that the big banks did not get where they are today through natural market competition. In other industries, dominant firms are characterized by focused excellence. Intel is very good at designing and manufacturing chips. Walmart is very good at logistics. What is JP Morgan Chase very good at? Citigroup?
Another characteristic of dominant firms in competitive markets is that they grow by doing more of what they are good at. In contrast, banks grow primarily through mergers and acquisitions.
4. How much does too-big-to-fail matter? Well, try to imagine what the computer industry would look like if the government had designated the dominant firms as of 1970 as too big to fail. We would still have Wang and DEC, but I doubt that we would have Apple or Microsoft.
5. If we imagine banks without TBTF, then it is likely that at times in the past the stock prices of some of the large banks would have been very low, which would have halted their growth through acquisitions and perhaps forced management to divest poorly-managed business lines in order to appease shareholders.
We cannot have large banks without TBTF. We cannot have TBTF without an unfair playing field and mockery of the rule of law. So we should break up large banks.