New FDIC Authority For Ending Too Big To Fail

From a speech by FDIC Chairman Sheila Bair, "Ending Too Big To Fail: The FDIC and Financial Reform", 2010 Glauber Lecture at the John F. Kennedy Jr. Forum, Harvard University, Cambridge, MA, October 20, 2010:

One of the most fundamental problems that led to the crisis was that a number of large banks and other financial companies were Too Big To Fail. This term is really just shorthand for the dilemma that policymakers faced in the Fall of 2008, when a number of these institutions ran into serious trouble.

We faced this choice: To let them fail, and risk destabilizing the entire financial system. Or to bail them out – imposing costs on the taxpayer and encouraging the type of risky behavior that caused the crisis in the first place. Needless to say, both of these options were highly problematic.

How did we get into this situation? One big reason is that neither bank holding companies nor non-bank financial companies, both of which figured prominently in the crisis, were subject to an FDIC-like receivership authority. That means they could not be resolved in an orderly fashion without bailing out debt and equity holders or disrupting the financial system. Instead, these entities were subject to the commercial bankruptcy process, where it takes a long time and a lot of money to determine what creditors ultimately stand to collect. For example, the Lehman Brothers bankruptcy has cost almost a billion dollars to administer so far, and many creditors still do not know where they stand. By contrast, because of our ability to plan in advance, the FDIC receivership process for insured banks and thrifts sorts most of this out over a much shorter time frame, and generally returns the failed institution to private hands right away.
***The Dodd-Frank Act for the first time gives the FDIC a similar set of receivership powers to close and liquidate systemically-important financial firms that are failing.
***Our proposed rule makes clear that some creditors will never be deemed essential to operations or maximizing value. It states clearly that shareholders, subordinated debt and long-term bondholders will never qualify to receive additional payments above their liquidation value under the statutory priority of claims.

It also affirms that secured creditors will only be protected to the extent of the fair value of their collateral, with any unsecured portion remaining subject to loss. By ensuring that all creditors know they are at risk of loss in a failure, this proposed rule is a solid first step in implementing the resolution authority under Dodd-Frank and ending Too Big To Fail.

Read Bair's complete remarks here.

Too Big To Fail Or Too Big To Survive

A thoughtful analysis and article by John Carney on Business Insider, "Why Do Banks Grow Too Big To Fail?"

So why are there big banks? The primary reason for any firm to grow is to avoid some of the transaction costs of using the markets. The transactions costs avoided by centralizing costs in one firm include the difficulty of discovery the relevant prices, as well as the costs of brokering deals and raising capital from outsiders.

But this avoidance of the market is also a disadvantage, as avoiding market prices subtracts from a bankers knowledge and makes efficient economic calculation difficult.

This is actually the central economic dynamics of a capitalist economy. Prices are important to economic calculation but they involve transaction costs. Eliminating transaction costs from dealing with external price markets is the leading explanation for why firms exist at all, and why they grow. But this also has a cost of making prices less transparent, and economic calculation more difficult. The size of any firm is probably dependent on how these things balance out: transactions costs and calculational chaos costs.

Read the entire article here.

I would add to Carney's article that the failure to have accurate pricing in the big institutions misled the firms on the riskiness of their endeavors, postponed the recognition, internally and on accounting statements, of the decline in the value of their investments in securitized assets and contributed to the credit tightening and financial crisis.