National Journal

This article is from the archive of our partner National Journal

The scariest thing about addressing "too-big-to-fail" banks is that there's no dress rehearsal. For all the plans, simulations, and preparations, the only way to know that the problem of banks being excessively interconnected in the wider economy has been solved is when one of these banks fails — but doesn't take the rest of the economy with it. Until that happens, elected officials and regulators are left to look back at the 2008 debacle and argue about whether they've put the pieces in place to keep it from happening again.

But in the midst of that argument, this much is clear: These banks are as big, or bigger, than they ever have been.

"They have a potential to have a catastrophic effect," says Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation. "They are larger than they were at the last crisis."

That does not mean that there haven't been attempts to mitigate the problem of banks being so large that they require a bailout. In the five years since Congress passed the Dodd-Frank Wall Street reform law, regulators have implemented a suite of measures aimed at ensuring that the nation's largest banks are sound and that, should they wobble, the economy won't go with them. The question of how to handle Wall Street, and what to do about Dodd-Frank, quickly is becoming a prime point of contention early in the 2016 presidential campaign.

To put it mildly, there's no consensus on whether Dodd-Frank has adequately addressed the too-big-to-fail question, or even if regulation is headed in the right direction.

So does the potential collapse of the biggest banks still pose a threat to the U.S. economy? And if it does, how can Dodd-Frank and other laws be changed so that megabanks are either safe from 2008-style failures, or can fail in such a way that they don't take everything down around them?

National Journal talked to top regulators, experts, senators, and presidential contenders in search of common threads on how to address too-big-to-fail. Here are the five options that lay out the lines for where policy moves from here.

The Default Option: Dodd-Frank Is Working, So Let It Be

Dodd-Frank was written in the aftermath of the bank bailouts and aimed to prevent them from happening again. Since the law's 2010 passage, a string of restrictions have been placed on banks with the aim of keeping them stable — and cushioning the blow should they go under.

Former Sen. Chris Dodd, one of the law's coauthors and namesakes, told National Journal that it has largely mitigated too-big-to-fail. Among the provisions that he says have made the financial system more stable are "living wills," a preset plan for winding down banks peacefully, reviewed by the Federal Reserve and FDIC, should they no longer be viable. He also pointed to the law's stress tests, which earlier this year showed that all 31 of the biggest banks subjected were strong enough to keep lending in the event of a shock to the economy.

"I think anyone suggesting that too-big-to-fail is still a reality, they don't know what they're talking about," Dodd said.

Other provisions include the creation of what's known as the Orderly Liquidation Authority, which would put a troubled bank in the hands of the FDIC and — through a tax on the biggest financial institutions — create a pool of money for the agency to use.

Dodd said banks have significantly increased their capital, raising more than $600 billion in recent years. Dodd also said for all the talk about breaking up the banks, the law gives the Financial Stability Oversight Council the authority to do so.

But Hoenig, whose FDIC sits on the council, says the authority to break up banks is insufficient and the reason the council has the authority is because Congress couldn't get to the point of breaking up the banks.

"You could do things, but in a growing economy where profits are being announced, who's willing to step up and break them up?" Hoenig said

Last year, the Fed and FDIC agreed that the banks failed to make or identify changes in firm structure necessary to enhance an orderly wind-down, which could cause concern if the banks do fail. This month, the banks submitted their wills.

As with most policy debates, criticizing existing law is far easier than putting a new option in place. And so, if Dodd-Frank isn't the answer on too-big-to-fail, or doesn't go far enough, what is the solution?

Increase Capital Requirements for Banks

One idea popular with experts across the board is requiring banks to hold onto more capital.

Despite changes in capital requirements after Dodd-Frank, Hoenig says many of the largest banks remain leveraged at a ratio of 20-to-1 — meaning that for every dollar of capital, they have $20 of debt.

"An individual institution is thus more likely to fail should there be a shock," Hoenig told National Journal. "Given that the whole industry is capitalized like that, it would affect the whole industry."

In 2013, Ohio Democratic Sen. Sherrod Brown and Louisiana GOP Sen. David Vitter proposed legislation that requires mid-sized and regional banks to hold capital that is the equivalent of 8 percent of their assets, and banks with more than $500 billion in assets would be required to hold 15 percent.

"Fixing much of this could have been done 10 years ago by higher capital requirements, which we failed to do, but we need to move more in that direction," Brown, now the ranking Democrat on the Senate Banking Committee, said at a press conference this month with Americans for Financial Reform.

But while Senate Banking Committee Chairman Richard Shelby said he'd support stronger capital requirements, he would leave capital requirements to regulators.

"That's why we need good regulators," the Republican told National Journal.

Threaten the Biggest Banks with Downsizing

Earlier this month, Tennessee GOP Sen. Bob Corker told Federal Reserve Chairwoman Janet Yellen he was concerned that the Fed was "not putting the pressure on these banks to deliver" when it came to their living wills, despite the central bank's concerns.

Former Maryland governor and current presidential candidate Martin O'Malley proposed that if banks don't create a credible plan that shows how they can go into bankruptcy without destroying the economy, he would order the Fed to downsize the banks.

It's not entirely clear how the president can instruct the Federal Reserve to take such an action, considering the independence of the central bank. But O'Malley said at the Center for National Policy on Thursday that communication from the White House could have a genuine effect on independent agencies such as the Federal Reserve.

Break 'Em Up

For other would-be Wall Street reformers, the megabanks are too big and broad to ever be safe. And to escape the failures of 2008, regulators need to look back to the 1990s, when Congress repealed Glass-Steagall's provisions separating commercial and investment banking.

Glass-Steagall was passed in 1933 during the Great Depression. Hoenig, an economist by trade, says when legislators introduced deposit insurance, which protects bank depositors from losses, they knew they were creating a moral hazard, where the banks would be protected against risk.

"They said 'alright, we are going to confine that to the commercial-banking business,' he said. "Investment banks, broker-dealer, high-risk trading activities, we're going to keep you away from the safety net so they broke those out"

By far, the best-known champion of a new Glass-Steagall measure is Massachusetts Democratic Sen. Elizabeth Warren. But she's not alone. When Warren introduced a bill reinstating the regulations in July, she was joined by Democratic Sen. Maria Cantwell, independent Sen. Angus King (he caucuses with Democrats), and Republican Sen. John McCain. Two Democratic presidential candidates, O'Malley and Sen. Bernie Sanders, have endorsed similar proposals.

"By separating depository institutions from riskier activities, large financial institutions will shrink in size and won't be able to rely on FDIC insurance as a safety net for their high-risk activities," Warren said in a recent floor speech introducing the bill.

Hoenig believes it would be an effective way to mitigate too-big-to-fail. "It is the best way, because it doesn't say size is the issue," Hoenig says. "The nature of the activity is the issue."

But Mark Calabria, director of financial-regulation studies at the Cato Institute, said there would be some banks, such as Wells Fargo, which don't get involved in securities activities but would still be pretty big even with a new Glass-Steagall style separation.

Former Rep. Barney Frank, the other coauthor and namesake of the law, said at an event at Third Way last week that he disagreed with Warren on the need to reintroduce Glass-Steagall. "Even if you did Glass-Steagall, you would still have institutions that are too big to allow them to fail without consequences," Frank said, adding that that if some of the largest banks were cut in half, there would be multiple new institutions that are too-big-to-fail.

Let 'Em Fail

For some, the only surefire way to make sure that banks do not think they will be bailed out by the government is to let them fail if they fall under distress.

"I would make it unambiguous that we're not going to tinker with you," Shelby told National Journal, also saying financial institutions should know if they take risks, they will be eaten up by the marketplace. "If that is unambiguous and people believe it, they are going to be careful in the kind of the risk they take."

To many in the "let it go" caucus, the problem of too-big-to-fail is not that the banks are actually too big, it's that politicians are willing to bail them out, and the banks know it — and take bigger risks because they think they'll always have a government safety net to fall back on.

Calabria, a former Shelby staffer, said legislation should not be about protecting banks, but rather about making it clear to them that, if they fail, the federal government's cavalry isn't coming.

"Too-big-to-fail is 100 percent a political phenomenon. It's the willingness of regulators to rescue these institutions and to protect creditors and essentially to bend the rules," he said. "A lot of the emphasis needs to be [on] how do you limit the choices of regulators, how do you pull back elements of the safety net?"

Some Republicans already are working off that theory: In their proposed budget earlier this year, Republicans proposed eliminating Dodd-Frank's Orderly Liquidation Authority, arguing that this rewards corporate failure with taxpayer dollars and that the responsibility for the failure of a bank should be on shareholders, managers, and creditors involved with the institution.

But the fact that there is still discussion about too-big-to-fail banks five years after a comprehensive law was passed shows that the anxiety from the 2008 crisis still lingers. And it still dominates how people view Wall Street.

The Default Option: Dodd-Frank Is Working, So Let It Be

Dodd-Frank was written in the aftermath of the bank bailouts and aimed to prevent them from happening again. Since the law's 2010 passage, a string of restrictions have been placed on banks with the aim of keeping them stable — and cushioning the blow should they go under.

Former Sen. Chris Dodd, one of the law's coauthors and namesakes, told National Journal that it has largely mitigated too-big-to-fail. Among the provisions that he says have made the financial system more stable are "living wills," a preset plan for winding down banks peacefully, reviewed by the Federal Reserve and FDIC, should they no longer be viable. He also pointed to the law's stress tests, which earlier this year showed that all 31 of the biggest banks subjected were strong enough to keep lending in the event of a shock to the economy.

"I think anyone suggesting that too-big-to-fail is still a reality, they don't know what they're talking about," Dodd said.

Other provisions include the creation of what's known as the Orderly Liquidation Authority, which would put a troubled bank in the hands of the FDIC and — through a tax on the biggest financial institutions — create a pool of money for the agency to use.

Dodd said banks have significantly increased their capital, raising more than $600 billion in recent years. Dodd also said for all the talk about breaking up the banks, the law gives the Financial Stability Oversight Council the authority to do so.

But Hoenig, whose FDIC sits on the council, says the authority to break up banks is insufficient and the reason the council has the authority is because Congress couldn't get to the point of breaking up the banks.

"You could do things, but in a growing economy where profits are being announced, who's willing to step up and break them up?" Hoenig said

Last year, the Fed and FDIC agreed that the banks failed to make or identify changes in firm structure necessary to enhance an orderly wind-down, which could cause concern if the banks do fail. This month, the banks submitted their wills.

As with most policy debates, criticizing existing law is far easier than putting a new option in place. And so, if Dodd-Frank isn't the answer on too-big-to-fail, or doesn't go far enough, what is the solution?

Increase Capital Requirements for Banks

One idea popular with experts across the board is requiring banks to hold onto more capital.

Despite changes in capital requirements after Dodd-Frank, Hoenig says many of the largest banks remain leveraged at a ratio of 20-to-1 — meaning that for every dollar of capital, they have $20 of debt.

"An individual institution is thus more likely to fail should there be a shock," Hoenig told National Journal. "Given that the whole industry is capitalized like that, it would affect the whole industry."

In 2013, Ohio Democratic Sen. Sherrod Brown and Louisiana GOP Sen. David Vitter proposed legislation that requires mid-sized and regional banks to hold capital that is the equivalent of 8 percent of their assets, and banks with more than $500 billion in assets would be required to hold 15 percent.

"Fixing much of this could have been done 10 years ago by higher capital requirements, which we failed to do, but we need to move more in that direction," Brown, now the ranking Democrat on the Senate Banking Committee, said at a press conference this month with Americans for Financial Reform.

But while Senate Banking Committee Chairman Richard Shelby said he'd support stronger capital requirements, he would leave capital requirements to regulators.

"That's why we need good regulators," the Republican told National Journal.

Threaten the Biggest Banks with Downsizing

Earlier this month, Tennessee GOP Sen. Bob Corker told Federal Reserve Chairwoman Janet Yellen he was concerned that the Fed was "not putting the pressure on these banks to deliver" when it came to their living wills, despite the central bank's concerns.

Former Maryland governor and current presidential candidate Martin O'Malley proposed that if banks don't create a credible plan that shows how they can go into bankruptcy without destroying the economy, he would order the Fed to downsize the banks.

It's not entirely clear how the president can instruct the Federal Reserve to take such an action, considering the independence of the central bank. But O'Malley said at the Center for National Policy on Thursday that communication from the White House could have a genuine effect on independent agencies such as the Federal Reserve.

Break 'Em Up

For other would-be Wall Street reformers, the megabanks are too big and broad to ever be safe. And to escape the failures of 2008, regulators need to look back to the 1990s, when Congress repealed Glass-Steagall's provisions separating commercial and investment banking.

Glass-Steagall was passed in 1933 during the Great Depression. Hoenig, an economist by trade, says when legislators introduced deposit insurance, which protects bank depositors from losses, they knew they were creating a moral hazard, where the banks would be protected against risk.

"They said 'alright, we are going to confine that to the commercial-banking business,' he said. "Investment banks, broker-dealer, high-risk trading activities, we're going to keep you away from the safety net so they broke those out"

By far, the best-known champion of a new Glass-Steagall measure is Massachusetts Democratic Sen. Elizabeth Warren. But she's not alone. When Warren introduced a bill reinstating the regulations in July, she was joined by Democratic Sen. Maria Cantwell, independent Sen. Angus King (he caucuses with Democrats), and Republican Sen. John McCain. Two Democratic presidential candidates, O'Malley and Sen. Bernie Sanders, have endorsed similar proposals.

"By separating depository institutions from riskier activities, large financial institutions will shrink in size and won't be able to rely on FDIC insurance as a safety net for their high-risk activities," Warren said in a recent floor speech introducing the bill.

Hoenig believes it would be an effective way to mitigate too-big-to-fail. "It is the best way, because it doesn't say size is the issue," Hoenig says. "The nature of the activity is the issue."

But Mark Calabria, director of financial-regulation studies at the Cato Institute, said there would be some banks, such as Wells Fargo, which don't get involved in securities activities but would still be pretty big even with a new Glass-Steagall style separation.

Former Rep. Barney Frank, the other coauthor and namesake of the law, said at an event at Third Way last week that he disagreed with Warren on the need to reintroduce Glass-Steagall. "Even if you did Glass-Steagall, you would still have institutions that are too big to allow them to fail without consequences," Frank said, adding that that if some of the largest banks were cut in half, there would be multiple new institutions that are too-big-to-fail.

Let 'Em Fail

For some, the only surefire way to make sure that banks do not think they will be bailed out by the government is to let them fail if they fall under distress.

"I would make it unambiguous that we're not going to tinker with you," Shelby told National Journal, also saying financial institutions should know if they take risks, they will be eaten up by the marketplace. "If that is unambiguous and people believe it, they are going to be careful in the kind of the risk they take."

To many in the "let it go" caucus, the problem of too-big-to-fail is not that the banks are actually too big, it's that politicians are willing to bail them out, and the banks know it — and take bigger risks because they think they'll always have a government safety net to fall back on.

Calabria, a former Shelby staffer, said legislation should not be about protecting banks, but rather about making it clear to them that, if they fail, the federal government's cavalry isn't coming.

"Too-big-to-fail is 100 percent a political phenomenon. It's the willingness of regulators to rescue these institutions and to protect creditors and essentially to bend the rules," he said. "A lot of the emphasis needs to be [on] how do you limit the choices of regulators, how do you pull back elements of the safety net?"

Some Republicans already are working off that theory: In their proposed budget earlier this year, Republicans proposed eliminating Dodd-Frank's Orderly Liquidation Authority, arguing that this rewards corporate failure with taxpayer dollars and that the responsibility for the failure of a bank should be on shareholders, managers, and creditors involved with the institution.

But the fact that there is still discussion about too-big-to-fail banks five years after a comprehensive law was passed shows that the anxiety from the 2008 crisis still lingers. And it still dominates how people view Wall Street.

This article is from the archive of our partner National Journal.

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