Why Kansas City Fed Chief Thomas Hoenig Thinks the Financial System is Riskier Than Ever
For as lucid an analysis as you're likely to read of why the Dodd-Frank financial reform law won't prevent another economic crisis, have a look at this new speech by Kansas City Federal Reserve Bank president Thomas Hoenig.
The central banker, whose criticism of the nation's monetary policy under Federal Reserve Chairman Ben Bernanke illustrates his willingness to speak his mind, says the biggest danger consists of financial firms that remain "too big to fail." While calling Dodd-Frank "well-intentioned," Hoenig says the threat to the financial system is "even worse than before the crisis." He adds:
Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place....
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 â€"- the growth of one is linked to growth of the other, in an increasingly pernicious cycle.As a result, creditors, investors and other players in the financial markets assume there is virtually no chance that the government will allow TBTF firms to collapse. That amounts to a huge competitive advantage for Wall Street banks. How big? The Kansas City Fed estimated that in 2009 the credit rating of the five largest U.S. banks' long-term debt was four notches higher than their actual financial condition warranted. One bank's rating got an astounding eight-notch upgrade for being deemed TBTF.
That presumption of government support means big banks don't have to sell creditors on their financial strength and allows them to more cheaply raise capital. It also encourages banks to take ever greater risks, making government bailouts even more certain. Hoenig says:
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.Why we're trapped in a "doom loop"
Bank of England official Andrew Haldane calls this recurrent pattern a "doom loop." And Dodd-Frank won't get us out of it, Hoenig says. Although the law calls for stricter supervision of big banks, that requires regulators to get a clear picture of a bank's condition and then act on what they've learned.
But that was enormously challenging even before financial firms exploded in size and complexity over the last 15 years. Factor in Wall Street's political clout and the odds of financial regulators taking "prompt corrective action" to rein in big banks grow even slimmer. He is similarly skeptical that the law's empowering regulators to shut down TBTF firms will avert future bailouts. That's because in a major crisis, the government will resist exercising this authority for fear of triggering panic in the financial markets.
Hoenig has a straightforward solution for what to do about TBTF firms:
For me, the answer is firm: They must be broken up. We must not allow organizations operating under the safety net to pursue high-risk activities, and we cannot let large organizations put our financial system at risk. Protected institutions must be limited in their risk activities because there is no end to their appetite for risk and no perceived end to the public purse that protects them.Sound advice. Regrettably, we're unlikely to consider it until doom loops around on us again.
Thumbnail from Flickr user andeecollard
Related:
- TARP Trap: How the Bank Bailout Saved the Financial World -- and Threatens it Anew
- What Does "Too Big to Fail" Really Cost?
- Now They Tell Us: Wall Street Doesn't Fear Dodd-Frank, Basel Reforms
- Why Ben Bernanke Will Regret Declaring Mission Accomplished on "Too Big to Fail"
- Financial Reform: Four Reasons Stricter Regulation Isn't Enough