More on Banks That Are Too Big To Fail

The following from the WSJ Economics Blog is a summary of comments made by the head of the Kansas City Fed. It is good to see that there are descending points of view at the Fed.

Also the post below makes reference to Simon Johnson, former senior economist at the IMF. He authored a very interesting article entitled The Quiet Coup in the Atlantic that compares the US economy with those in emerging market countries. A really good read.

Certain firms are not too big to fail and must be allowed to do so to help the U.S. economy and financial markets heal, Federal Reserve Bank of Kansas City President Thomas Hoenig said Tuesday.

Hoenig said that protecting the country's largest institutions from failure risks prolonging the current crisis and increasing its cost. Of particular concern, he said, is that financial support provided to these firms gives them a competitive advantage over other firms and subsidizes their growth and profit with taxpayer funds.

“The United States currently faces economic turmoil related directly to a loss of confidence in our largest financial institutions because policymakers accepted the idea that some firms are just “too big to fail,'” the central banker said. “I do not.”

The central banker was delivering a prepared statement before the Joint Economic Committee of the U.S. Congress. Also appearing at the hearing were former IMF chief economist Simon Johnson and Nobel laureate Joseph Stiglitz. Hoenig is currently a nonvoting member of the interest-rate setting Federal Open Market Committee.

Hoenig said that pouring more money into large firms in hope of a turnaround may be tempting, but despite record levels of spending, confidence and transparency have not returned to financial markets. Key for a full economic recovery is restored confidence, Hoenig said.
Hoenig added that in “the rush to find stability,” no clear process was used to allocate TARP funds among the largest firms. That created further uncertainty, he said, and is impeding a recovery.

The central banker said that systemically important financial firms should be triaged based on their current condition. Well-capitalized firms should be left as is. Viable firms that need more capital should privately raise the capital or seek government assistance, with the taxpayer put in the senior position and the government determining the circumstances of the senior managers and directors. Nonviable institutions should be allowed to fail.

Nonviable institutions could be put into a negotiated conservatorship, as was done in 1984 with the holding company Continental Illinois, he said.

“Such a resolution process is equitable across all firms, has worked in the past, and favors taxpayers,” Hoenig said.

Past experience also suggests the approach costs much less than the alternative of not recognizing losses and allowing forbearance, he said, as Japan initially did with its problem banks during the “lost decade” and as the U.S. initially did with thrifts in the 1980s.

In his remarks, the central banker also said that regulatory reform is key as the crisis subsides and old habits remerge. Because they are complex and politically influential, “too big to fail” firms cannot be supervised on a sustained basis without a clear set of rules constraining their actions, he said. He said history has shown strong limits on leverage ratios work.

Hoenig also noted that the structure of the Federal Reserve System is not the problem, as has been recently suggested.