Fed’s Focus on “Too-Big-to-Fail” Won’t Save Taxpayers From the Next Bank Bailout

Last month, the Federal Reserve announced that 31 out of 33 U.S. banks had passed its latest “stress test,” designed to ensure that the largest financial institutions have enough capital to withstand a severe economic shock.

Passing the test amounts to being given a clean bill of health by the Fed. So are taxpayers — who were on the hook for the initial US$700 billion TARP bill to bail out the banks in 2008 — now safe?

Yes, but only until the next crisis.

Skeptics of these tests (myself included) argue that passing them will not prevent any bank (large or small) from failing, in part because they’re not stressful enough and the proposed capital requirements are not high enough.

But beyond this, the stress tests highlight a significant shortcoming in how regulators hope to prevent the next wave of bank failures: They’re focusing way too much on size, particularly with the designation of so-called systemically important, “too-big-to-fail” banks.

U.S. lawmakers in search of a solution are currently working on legislation that would make it easier for too-big-to-fail banks to actually fail through bankruptcy. While doing so would be a good thing, it still raises important questions.

Are policymakers right to focus on size in determining whether a bank poses a major risk to the financial system and taxpayers? Would splitting larger banks into smaller ones free taxpayers from the repeated burden of rescuing them during times of crisis? Does calling a bank “too big to fail” even mean anything?

To me, this focus on size and “too big to fail” seems misplaced. I’m among those who advocate replacing our current system with something known as “narrow banking,” which would totally separate deposits from riskier lending activities. This would have the best chance of protecting taxpayers from having to foot the bill for future bailouts, as I’ll explain below.

Read on.

 

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