What does the financial market and the electric grid have in common? If either goes down, things will get very, very ugly for the public. This raises a question: should big banks be regulated as utilities? At a conference this week, Kansas City Federal Reserve Bank President Thomas Hoenig asserted that big banks already are public utilities, since they're implicitly government-backed. As a result, he suggests regulating them like utilities. Is he right?
For those who do not remember Hoenig, he was the maverick member of the Fed's Open Market Committee who regularly dissented on the Fed's monetary policy decisions last year. He worried that its monetary stimulus had gone too far, and feared that additional expansion would make the Fed's exit impossible without triggering excessive inflation.
Although he rotated out of the FOMC this year, he's still managing to make news. Here's Joe Rauch at Reuters reporting on Hoenig's remarks:
The 2008 bank bailouts at the height of the financial crisis and other implicit guarantees effectively make the largest U.S. banks government-guaranteed enterprises, like mortgage finance companies Fannie Mae and Freddie Mac, said Kansas City Fed President Thomas Hoenig.
"That's what they are," Hoenig said at the National Association of Attorneys General 2011 conference.
He said these lenders should be restricted to commercial banking activities, advocating a policy that existed for decades barring banks from engaging in investment banking activities.
"You're a public utility, for crying out loud," he said.
There a few things to sort through here. First, receiving a bailout does not necessarily make a company a utility. Systematically receiving bailouts whenever you need one, however, could arguably make you a utility. After all, if the government will never allow you to fail due to the problems the public would face, then you cannot be treated like other firms, since you are not susceptible to failure. In this case, a firm should be regulated as a utility.
But is it necessarily true that banks remain too big to fail? This is a controversial question. Last summer's financial regulation bill took some measures to strengthen the big banks' status as too big to fail, but it also attempted to put a resolution authority in place that would ensure giant megabanks would be wound down if they collapse.
In practice, however, it's pretty implausible that the economy could be stabilized during a financial crisis like the one we experienced in 2008 without a government rescue. If every big bank is on the verge of collapse, you can't wind down all of them simultaneously. And you can't be sure that just one or two big ones would have failed without others following. The issue was that all big banks were stricken with toxic mortgage securities, and nobody knew how big their losses would be. Panic only subsided when the government stepped in to backstop the industry.
So is Hoenig right then? Is the answer to restrict big banks to commercial activities? It's hard to see how this would have helped during the crisis. Did the Lehman Brothers collapse harm financial markets? Of course it did, but it was not a commercial bank. Would the failures of Goldman Sachs, Merrill Lynch, and Morgan Stanley have been easily absorbed by the economy? Of course not: the entire financial market would have been in total disarray. Indeed, even the failure of AIG would have been catastrophic -- so you can't even limit the list of systemically important firms to banks.
The problem wasn't the size of banks or their mixture of commercial and investment banking. Instead, their interconnectedness created a dangerous situation when they faced failure.
One way to partially fix this problem would be to ensure that markets will not seize when a firm fails due to logistical problems, like closed market channels. The new resolution authority and its required living wills should help to ensure that such obstacles don't necessitate bailouts. But if several big firms fail simultaneously, then all the planning in the world might not help.
And this is where Hoenig's comments come back into the discussion. If the financial industry is too important to shut down for several months on end during a crisis scenario, then the government must regulate it so that it cannot fail all at once. That means limiting the risks big banks can take, like putting a reasonable ceiling on their borrowing (limiting leverage), capping debt concentration in a single sector, ensuring they have enough capital on hand to cover even deep losses, and limiting their short-term debt.
Some of these steps have already been taken by the financial reform bill and by regulators. We can't be certain that they'll prevent another financial crisis. If they were crafted properly, however, then they should create a safer market, where the failure of a few firms won't bring down the entire sector.