The Dilemma of "Too-Big-To-Fail"

The "too-big-to-fail" problem is defined as the government using taxpayer dollars to rescue "systemically important" banks. Federal Reserve Chairman Ben Bernanke said that regulatory reform would fail if it did not contemplate a system where Goldman Sachs could take bankruptcy and its creditors lose money. So far banking reform has fallen short of what Bernanke wanted. More importantly, the solutions being debated may increase overall risk instead of reducing it.

The expectation of bailouts gives banks no incentive to take precautions against greater risks. Bank rescues can cause worldwide economic problems.

According to Ernie Patrikis, a partner in White & Case LLP, banking regulators want banks safe, sound, and big. Multinational firms see large money-center banks as indispensable. They provide investment banking and capital-raising. They are some of the best-run banks in the country per JoAnn Lilek of consulting firm Accretive Solutions and former CFO of Midwest Bank Holdings.

Many financial executives feel irresponsible management should suffer consequences, but worry that middle-market companies would be more vulnerable without a government safety net. Large corporations can increase their stable of lenders, smaller companies have to concentrate their credit relationships with one or two banks to get access to debt.

The question is "Can U.S. banking regulators solve the too-big-to-fail problem without causing financial institutions higher capital costs and subjecting banks customers to another credit crunch, or granting banks an incredible amount of political independence?"

It seems unwise to let operating entities of big banks to declare the kind of Chapter 11 in which they enter a turnaround situation or are acquired without government assistance. Under the current regulatory framework it would be nearly impossible per restructuring experts. Jacen Dinoff of KCP Advisory Group says "you're not going to see a bank file Chapter 11 and sit in bankruptcy winding down its assets while depositors petition as creditors to get percentage recoveries on life savings."

The Dodd-Frank Wall Street Reform and Consumer Protection Act does limit how far regulators will go in propping up a large bank. The FDIC has powers to dismantle the largest financial firms when they falter; the FDIC becomes a receiver for a bank if its failing presents a systemic risk to the financial markets.

During the Latin American debt crisis U.S. regulators took a very measured approach. They let the largest banks work out their problems over an extended period, rather than forcing them to recognize losses if they had to sell the debt immediately. Per Sandy Brown, of Bracewell & Giuliani LLP, "In the next crisis, multiple institutions will experience problems simultaneously, and regulators need flexibility to work in a manner that is not terribly hasty."

Time is not something regulators want to give failing banks. Globally there is a concentrated push to get national regulators to intervene sooner.

An early intervention strategy is no cake walk. There are at least two problems: First, spotting a bank that is headed for failure is not easy. Second, if U.S. regulators do catch problems early, there may be no resolve to take action.

Dodd-Frank ensures that taxpayers will no longer bear all the burden of federal rescues. In a perfect world banks and their investors will bear some or all of any losses. If regulators instill a sense of greater market discipline on investors, the hope is that investors will become better watchdogs of bank risk-taking.

No changes would necessarily change the risky behaviors of large banks or eliminate another global banking crisis. Nor would changes preclude the U.S. from rushing to the aid of giant, crippled institutions. So, the too-big-to-fail problem is still with us. And, it could get bigger. There is nothing to prevent more banks from entering the too-big-to-fail fraternity. Banks get bigger when larger institutions merge with troubled banks. And so it goes around and around.

The Big Fail, CFO Magazine, April 2011