The recent financial crisis was one of the world's worst and most pervasive. Actions taken affecting an array of institutions during the crisis, like each crisis before it, set new precedent and invited new risks going forward.
First, during the crisis public safety nets and assistance were stretched far beyond anything that we had done in past crises. Deposit insurance coverage was substantially expanded and public authorities went well beyond this with guarantees of bank debt instruments, asset guarantees at selected institutions, and many other forms of market support. Discount window lending sharply departed from previous practices in terms of nonbanks and special lending programs. Substantial public capital injections were further provided through TARP to the largest financial organizations in the United States and to several hundred other banks on a scale not seen since the Reconstruction Finance Corp. in the 1930s. These steps were similar to those that many other major countries took.
Second, at the heart of the financial collapse were some of the largest commercial and investment banks in the country, as well as the markets in which these institutions were key players. The five largest investment banks failed, were forced into mergers, or had to convert to bank holding company ownership to gain the necessary support. Bank of America and CitiGroup both required extensive assistance to pull through this crisis. Special assistance was provided to AIG, the largest insurance company in the United States. In addition, Fannie Mae and Freddie Mac belong in this group because of the influence they exert over the U.S. mortgage market, their enormous losses, and public takeover.
It is no coincidence that two principal features of this crisis were heavily bloated safety nets and major financial institutions that were treated as being too big to fail. History shows that these two elements have become more intertwined-the growth of one is linked to growth of the other, in an increasingly pernicious cycle.
Over time we have experienced a ratcheting process in which public authorities are pressured to widen and deepen their state safety nets after every financial crisis brought on by excessive bank risk taking. This expansion in safety nets then sets the stage for the next crisis by providing even greater incentives for risk taking and further expanding moral hazard problems.
As a result, we have become trapped in a repeating game in which participants continue to seek ever higher and more risky returns while "banking" on the state to fund any losses in a crisis. Large organizations, moreover, are the key players in this process as states become more immersed in the perception during a crisis that they must protect any bank regarded as systemically important. We must stop this game if we are to create a more stable financial system and not condemn ourselves to an escalating series of crises with rapidly rising costs.
Over the decades of crisis and bailouts there is considerable evidence of increasing levels of banking risk, which includes the long-term declining trend in bank capital and liquidity ratios, higher and much more variable returns on bank equity in recent years, and a link between higher leverage and the expansion in trading assets among large organizations.
In the United States, we observe with each crisis and market collapse that policymakers consistently intervene to protect an ever broader group of creditors and investors from loss. This includes the LDC debt crisis, the failure of Continental Illinois, and the thrift industry and stock market collapses of the 1980s. These previous public interventions, though, pale in comparison to what was done recently. Market participants and large financial institutions have little reason to doubt that they will be bailed out again.
Let me offer just one staggering example. When Gramm-Leach-Bliley was passed in 1999, the five largest U.S. banking organizations controlled $2.3 trillion in assets, or about 38% of all banking industry assets. Currently, Bank of America by itself and in spite of its need for government support during the crisis has the same level of assets-$2.3 trillion-as the top five did in 1999 and the top five now have 52% of all banking industry assets. What clearer sign could we find that market discipline no longer exists?
Past actions and this growth have given our largest organizations significant competitive advantages over other financial institutions. For example, creditors and uninsured depositors at too-big-to-fail organizations believe that there is almost no chance that they will have to take a loss. This idea is formally acknowledged by the credit rating agencies when they give these organizations separate "support" and "standalone" ratings, which explicitly factor in the government support they likely will receive. The difference in these two ratings thus provides one measure of the funding advantages that too-big-to-fail organizations have over others.
At the Federal Reserve Bank of Kansas City, we estimated the ratings and funding advantage for the five largest U.S. banking organizations during this crisis. In June 2009, these organizations had senior, long-term bank debt that was rated four notches higher on average than it would have been based on just the actual condition of the banks, with one bank given an eight-notch upgrade for being too big to fail. Looking at the yield curve, this four-notch advantage translates into more than a 160 basis point savings for debt with two years to maturity and over 360 basis points at seven years to maturity.
In a competitive marketplace, where just a few basis points make a difference, these funding advantages are huge and represent a highly distorting influence within financial markets. I'll name three. They don't have to sell creditors on the strength of their condition. They have significant advantages in competing for funds. And, they have significant incentives to take on more risk, hold less capital, and book more assets.
The idea of more effective regulation and supervision is a major focus in the Dodd-Frank Act. This act mandates enhanced supervisory standards for all systemically important financial institutions. Such standards are to include provisions for risk-based capital, leverage, liquidity, overall risk management, exposure concentration limits, and resolution plans and living wills.
With my supervisory background, I certainly support such efforts. But we should also recognize that supervision alone is not sufficient to address the challenges we face.
As an example, two decades ago we were told that supervision based on "prompt corrective action" was the answer to the thrift and banking crisis of the 1980s. This system may have led to more timely supervisory enforcement steps and established a timeframe for the resolution of most institutions. But prompt corrective action, other previous supervisory reforms, and enhanced supervision under Dodd-Frank, still must rely on examiners unfailingly coming up with an accurate picture of a bank's condition and then being able to act on those findings.
In large, complex organizations, this is an exceedingly difficult task and much more so than when I spoke about it 15 years ago. This crisis, in fact, confirms that even the senior management, boards, and financial experts at our largest banks failed to assess adequately the risks they were taking, even though they were involved with such issues on a constant basis and had their reputations at stake.
Also, as I previously stated, the substantial incentives that large organizations have to take on more risk, with the government expected to pick up the losses should they incur, unfailingly lead to undue risks throughout the balance sheet. In the hands of any banker, the combination of competitive pressures and perverse incentives are almost certain to result in noticeably higher risk exposures. Against these odds, we cannot expect examiners to have a 100% success rate. Factoring in the political power of the largest institutions, we cannot expect even a modest success rate during the upswing in the cycle.
In addition, too-big-to-fail incentives have provided an irresistible motive for large banks to game any capital system, particularly since their uninsured creditors do not count on capital but on a bailout for protection. There were several notable signs of this "gaming" of capital standards leading up to the crisis, including the growth of off-balance-sheet activities and the construction of subprime mortgage-backed instruments that marginally met the standards for AAA credit ratings. Even with firmer leverage standards, the incentive is for these organizations to increase balance sheet risks.
Resolution policy for too-big-to-fail institutions: A third option is to establish a framework for resolving systemically important institutions. I would add that this framework-to be successful-must convince all market participants that they are fully at risk when dealing with these entities.
Most important, this option offers the only direct means to address the incentive issues surrounding too big to fail and, as a result, provides the best opportunity to curtail the repeated game of expanded safety nets and escalating risk. Ending too big to fail in this manner would also bring market discipline back into play as a key force supporting supervision and capital standards.
Thomas Hoenig is president of the Federal Reserve Bank of Kansas City.
