Too Big to Fail: Big Banks & Crisis

The initial period of American banking, from the Founding Fathers' era, reveals a cautious approach toward concentrated financial power. The creation and subsequent demise of both the First and Second Banks of the United States illustrate this inherent skepticism. The First Bank's charter was allowed to lapse, and the Second Bank, under Nicholas Biddle, faced opposition from President Andrew Jackson, who viewed its economic influence on Congress with suspicion, famously stating his intention to 'kill' the bank. This early history highlights a recurring theme of concern regarding the potential for banks to wield excessive power and influence, shaping the landscape of future banking regulations and the ongoing debate over the appropriate level of government oversight.

The Panic of 1907, triggered by attempts to manipulate the stock price of the United Copper Company, exposed the fragility of the American banking system in the absence of a central bank. The ensuing bank runs and subsequent asset liquidations highlighted the need for an institution capable of providing liquidity during financial crises. J.P. Morgan's intervention, though partially successful, further underscored the systemic vulnerability. While bankers sought bailout assistance, reformers like Louis Brandeis advocated for stronger regulation. This period laid the groundwork for the creation of the Federal Reserve, introducing a new era in banking governance, though one marked by ongoing tension between the desire for stability and the resistance to greater regulatory control.

The Glass-Steagall Act of 1933, enacted during the Great Depression under President Franklin D. Roosevelt, represented a significant shift toward stricter banking regulation. This legislation separated commercial and investment banking activities, providing a much-needed framework to stabilize the financial system and to mitigate the risk of future banking crises. The act created the Federal Deposit Insurance Corporation (FDIC), offering deposit insurance that reassured customers and lessened the risk of bank runs. This regulatory regime successfully ushered in an era of relative stability, lasting approximately 50 years and showcasing the potential for robust regulation to safeguard against significant financial upheaval, a period of prosperity despite the ongoing Cold War and other geopolitical challenges. Even during this period of growth, concerns existed about issues such as CEO compensation compared to average worker pay, showing an underlying tension between economic success and equitable distribution of wealth.

Beginning in the 1970s, inflationary pressures and a prevailing anti-regulation sentiment fueled a movement towards financial deregulation. This shift, particularly under the Reagan administration in 1980 and subsequent years, reversed decades of established regulatory frameworks. The savings and loan crisis of the 1980s serves as a stark example of the consequences of this approach. Deregulation continued into the Clinton administration, and, importantly, under Alan Greenspan's leadership at the Federal Reserve. The Riegle-Neal Act of 1994 removed interstate banking restrictions. However, simultaneous efforts to curb predatory lending through the Home Ownership and Equity Protection Act were largely undermined by the Federal Reserve’s inaction. The failure to enforce consumer protection laws allowed for a rise in risky lending practices, notably subprime lending, all but guaranteeing the vulnerability of the system to the impending financial crisis.

A key factor contributing to the 2008 financial crisis was the prevailing deregulatory environment, particularly during the Clinton and Bush administrations. This climate, coupled with the libertarian views of Alan Greenspan, then-chairman of the Federal Reserve, fostered an environment where risk-taking was not adequately constrained. The absence of robust oversight allowed for the proliferation of increasingly complex and risky financial instruments, including subprime mortgages, adjustable-rate mortgages, and credit default swaps. These innovative products, while initially praised for expanding credit access, ultimately fueled a housing bubble and created systemic vulnerabilities within the financial system. The deregulation facilitated the creation of toxic assets which, when they began to fail, had a devastating ripple effect. The lack of sufficient regulation created an environment where institutions could profit from these products while ignoring the potential for disastrous consequences, ultimately leading to the economic meltdown.

The 'too big to fail' (TBTF) doctrine played a significant role in the crisis. Large banks, including JPMorgan Chase, Bank of America, and Citibank, became so interconnected and influential that their failure was deemed too catastrophic to allow. This implicit government guarantee fostered excessive risk-taking, as these institutions felt shielded from the consequences of their actions. The substantial government bailouts, totaling over $12.8 trillion according to Bloomberg, highlight the immense cost of this policy. These institutions, instead of lending to small- and medium-sized businesses, diverted funds towards trading, demonstrating a lack of responsibility towards the broader economy. The JP Morgan 'London Whale' trading loss of billions is an example of this misallocation of resources and exemplifies the risks associated with the TBTF problem.

The 2008 financial crisis had a devastating impact on the global economy, resulting in massive job losses exceeding 700,000 jobs per month at one point. The initial $700 billion bailout, while preventing an immediate collapse, proved insufficient to fully address the crisis's long-term consequences. The Obama administration's stimulus package, while intended to restart the economy, was ultimately inadequate. The article suggests the Dodd-Frank Act was also insufficient, failing to directly address the power and risk-taking culture of the largest banks. The continued struggle of the American economy years after the crisis, contrasted with Sweden's relatively quick recovery following a similar crisis in 1991 (where losses were recognized and a portion of the banking system was nationalized), points to the inadequacy of the measures taken in the United States. The immense lobbying efforts by the financial services industry, exceeding $570 million during the 2011-2012 election cycle, are presented as evidence of the ongoing struggle for regulatory reform.

The article centers on the concept of 'too big to fail' (TBTF) banks and their negative impact on the economy. The sheer size of these institutions—JPMorgan Chase, Bank of America, Citibank, and Wells Fargo are cited as examples, possessing trillions of dollars in assets—creates a systemic risk. Their immense size makes them difficult to manage and regulate effectively. The 'too big to fail' problem leads to a moral hazard, whereby these banks take on excessive risks, knowing that the government is likely to bail them out in case of failure. This lack of accountability is highlighted by comparing the treatment of the big banks after the 2008 crisis to the conditions imposed on General Motors after its bailout, showing a significant difference in accountability. The article emphasizes that this lack of accountability further encourages risk-taking behavior and stifles competition. The considerable taxpayer subsidies these banks receive as a result of the implicit guarantee only exacerbate the issue, further distorting the competitive market.

The central argument is that breaking up the largest banks would yield significant benefits. Smaller, more manageable entities would be easier to monitor and regulate, leading to more realistic oversight from boards of directors and market forces. The inherent complexity of the current mega-banks' operations contributes to instability and makes thorough risk assessment extremely challenging. This increased transparency and reduced complexity would decrease systemic risk and facilitate better pricing of risk. Breaking them up would also foster greater competition within the banking sector, allowing for a healthier and more dynamic market. Furthermore, this restructuring would alleviate conflicts of interest within these vast institutions, enabling a clearer focus on providing essential banking services rather than engaging in risky, short-term trading for massive profits.

The Dodd-Frank Wall Street and Consumer Protection Act aimed to mitigate the 'too big to fail' problem by creating an Orderly Liquidation Authority (OLA). However, the article suggests this was insufficient to address the core problem. The OLA, designed to facilitate the liquidation of failing banks without jeopardizing the economy, is viewed as insufficient to prevent future bailouts due to the considerable influence and lobbying power of the banking industry. The continuous spending by the financial services industry on lobbying further hinders effective reform. Even proposals like requiring banks to create 'living wills'—breakup plans in case of trouble—are deemed insufficient if not properly enforced and publicly disclosed. Experts from the Federal Reserve Bank of Dallas and others argued that downsizing these massive institutions is necessary to prevent future crises, emphasizing the need for a change in the underlying ideology that views government intervention as inherently problematic.

The dramatic increase in subprime and Alt-A loans between 2000 and 2005 is highlighted as a key driver of the financial crisis. The number of subprime loans surged from 456,631 in 2000 to 2,284,420 in 2005, while Alt-A loans increased from 78,183 to 1,447,782 during the same period. These loans, often characterized as 'liar loans' due to lax underwriting standards, were championed by Alan Greenspan as beneficial financial innovations. The introduction of products like pick-a-pay loans, which allowed borrowers to choose payment amounts potentially less than the accruing interest (leading to negative amortization), further exacerbated the risk. This period of rapid growth in subprime mortgage lending, while initially appearing to foster broader access to credit, ultimately laid the groundwork for a catastrophic collapse of the housing market. The sheer volume of these loans, originated and securitized at a rate of $1 billion a day according to the Financial Crisis Inquiry Commission, overwhelmed quality control processes, leading to widespread risk.

The involvement of credit rating agencies is critically examined. Relying on outdated data from the pre-2000 real estate market, rating agencies assigned AAA ratings to mortgage-backed securities (MBSs), despite the fundamental shift in the market dynamics. Investment bankers paid handsomely for these ratings, prioritizing volume over quality. The creation of complex structured products such as collateralized debt obligations (CDOs), which bundled mortgages into tranches with varying levels of risk and return, further obscured the underlying risks. The transfer of risk assessment from government regulators to these credit rating agencies, which had a vested interest in the financial industry's success, created a major flaw in the system. This allowed financial firms to hold minimal capital against securities rated AAA, which later proved to be of significantly lower quality, contributing directly to the financial crisis.

The article focuses on credit default swaps (CDSs) as a particularly problematic financial innovation. Raghuram Rajan's research on financial risk is cited, highlighting the 'hidden tail risk' associated with instruments like CDSs, which offer high profitability with seemingly low risk, allowing for concealed risks with potentially catastrophic consequences. The Abacus transaction, where Goldman Sachs created a synthetic CDO without disclosing the involvement of an investor betting against the housing market, serves as a prime example of this moral hazard. The case demonstrates the potential for extremely lucrative but high-risk financial instruments to contribute to the instability of the system when coupled with insufficient regulation and transparency. The JP Morgan 'London Whale' episode shows a similar situation of failed risk management in complex derivatives trading, where hedging activities became profit centers, ultimately resulting in substantial losses.