Too Safe to Fail; Requiring Big Banks to Build Cash Reserves Can Prevent Future Failures

Article excerpt

Byline: William M. Isaac and Cornelius Hurley, SPECIAL TO THE WASHINGTON TIMES

The finance ministers of the Group of 20, meeting in Paris last weekend, signaled their intention to address the issue of too-big-to-fail (TBTF) financial firms at their next meeting. The Paris communique calls for higher loss absorbency measures and levies on systemically important financial institutions.

It is well-documented that TBTF firms enjoy a substantial taxpayer subsidy in the form of lower borrowing costs. The markets recognize that countries cannot allow their largest financial institutions to fail. In the United States, for example, the five largest banks control more than 50 percent of banking assets. The economic impact of their failure would be devastating.

As a result of this subsidy, the TBTF firms have morphed into versions of Fannie Mae and Freddie Mac, absent the public mission those twins hide behind. Privatize the gains and socialize the losses - sound familiar?

The deeply flawed Dodd-Frank Wall Street reform act resigns us to a world where the TBTF firms become even larger and more threatening. Rather than root out the problem, the new law attempts to address it through extensive government involvement in micromanaging those firms and selecting winners and losers. Nothing in economic history inspires confidence that government can successfully manage private-sector firms.

There is a bold, simple and workable solution that all can embrace. This plan balances the two pillars of democratic capitalism - regulation and market discipline. It places the ultimate fate of TBTF firms where it belongs, in the hands of their shareholders, while protecting the financial system and taxpayers from future TBTF meltdowns.

First, identify the handful of TBTF institutions. Largely, the regulators and the credit-rating agencies already have done this (Goldman Sachs, Citigroup, Bank of America, JPMorgan Chase, UBS, Barclays, Deutsche Bank, etc.).

Second, require each TBTF firm to establish a separate reserve account on its balance sheet funded by the annual taxpayer subsidy it enjoys as a result of its privileged status and lower funding costs. (We call it a subsidy reserve. ) Treated as capital for liquidation purposes but not for regulatory purposes, the subsidy reserve is calculated based on the support versus stand-alone ratings currently assigned by credit-rating agencies. …