Risk of Overcapitalizing ‘Too Big To Fail’ Banks, Another Recession

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Charles Plosser, President and Chief Executive Officer of Federal Reserve Bank of Philadelphia, gave a speech on Thursday afternoon discussing how to end the “Too Big To Fail” conundrum of the big banks at the fourth Annual Simon New York City Conference. We are not interested in regurgitating Plosser’s speech today. What we want to show you is how and why the “too big to fail” conundrum cannot easily be solved and why it is so difficult to just unbundle the concentration of risk here.

This is an interesting take because it has yet another call to increase the capitalization of the so-called too big to fail banks. It sound great and 24/7 Wall St. is all in favor of big banks being on solid ground. The ultimate problem is that the big banks are so big that increase their capitalization requirements effectively withdraws too much capital from the economy.  It is without any doubt that you have heard of the calls to break apart the big banks before. You will here those same calls tomorrow and beyond as well.

When you consider that a mere handful of banks have about half of the country’s personal and commercial bank deposits you have a right to be scared. Increasing the capital requirements above the 10% hurdles set by Basel banking standards. Imagine how strong and able these banks would be able to hold up in another recession if their bank capital requirements went from 10% to say 15%.   Now for the bad news if you look at the tally of assets as of the end of 2012. J.P. Morgan Chase & Co. (NYSE: JPM) was about $2.36 trillion in assets and Bank of America Corporation (NYSE: BAC) has $2.2 trillion in assets, with Citigroup Inc. (NYSE: C) behind it at $1.86 trillon and then followed by $1.42 trillion for Wells Fargo & Co. (NYSE: WFC).

These four banks alone have $7.84 trillion in assets. The CIA World Factbook tracks just about all global economies and its final estimate for 2012 GDP was put at $15.66 trillion for 2012. Different regulators have many different means of calculating what they think the capitalization are best and keeping up with the flavor of the day or week is for government accountants and regulators. Still, this asset base for just the four biggest banks is right at half (actually 50.06%) of 2012 GDP on the purchasing power parity calculation preferred by economists.

It is very easy to merely say in a vacuum that the too big to fail banks should just increase their capital to hedge against future bailouts. Various regulators have various means of evaluating capitalization metrics and requirements. The unfortunate outcome is that by forcing banks to hold even more capital will tighten credit even further than it has been. With much of the world back in recession, that puts the U.S. back in recession.

Here is what Mr. Plosser said,

“Today, I will highlight why I think current efforts may not be sufficient and discuss a two-pronged approach to ending the problem of too big to fail. The first aspect of this approach is establishing a framework that permits a large financial institution to, in fact, fail without placing the financial system at risk. Large financial firms, and particularly their creditors, should not be rescued or protected by government guarantees or supports or by regulatory discretion. The second line of defense that I will discuss is to expect all financial firms to maintain sufficient levels of capital to significantly reduce the ex-ante risk of failure. Increased capital requirements can lower the incentive for financial institutions to become systemically important and lower the probability that such firms will fail in the first place.”

There is an admission that these “TBTF” banks would become less systemically important. We have no problem with the notion that 20 of the top 50 banks should be allowed to grow and take assets from the top 4. The question is how you can do it without creating a recession. No one seems to have the stomach to actually break apart these businesses. Merely lifting capital reserve requirements comes with a serious price due to the economies of scale here.

Finally, just imagine breaking all of these big banks up as the ultimate step that many people would like to see. This would be very messy and would likely throw the economy back into a self-imposed recession. At first there would be many layoffs and many immediate hits in the economy. That would likely reverse itself and perhaps in as short as one or two quarters of the year. During that period of chaos, businesses would have limited access to capital again just like in 2008 and 2009 at the same time that individuals would not be able to easily get mortgages and loans. The list of problems can just go on and on even though we agree that the big banks are just too big and too economically important.

It is easy for politicians and regulators to propose more strict and tighter standards. As you can see, the actual path to take is harder to walk down than it is to talk about. If you do not believe that there would not be real problems here, ask yourself why the moves have been so slow even after the financial crisis. Even with the anti-money sentiment that much of the public and their elected officials have today, the powers that be must also believe that the price to pay would be too costly.