A dangerous new chapter in ‘too big to fail’

A dangerous new chapter was recently opened in the on-going debate concerning whether large, global banks are Too-Big-To-Fail (TBTF) and its corollary, Too-Big-To-Jail(TBTJ).

Banking regulators from Switzerland are reportedly lobbying the U.S. government to consider the impact their banks have on the entire financial system (“systemic importance”) when considering the size of fines to impose for past illicit actions. Swiss banks are not alone, as an earlier $10 billion fine to the French bank BNP Paribas resulted in French President Hollande complaining to President Obama about it. Financial markets are now rattled over a potential $14 billion fine to Germany’s Deutsche Bank. Given the Bank’s existing problems, this fine could be large enough to trigger some of the alarm bells instituted post financial crisis on systemically important financial institutions.

Should policy makers and regulators consider the systemic nature and current health of a bank as part of determining the appropriate level of fine? No, it would set a dangerous and unwise precedent.

Should policy makers and regulators consider the systemic nature and current health of a bank as part of determining the appropriate level of fine?

Everyone should forcefully oppose the argument that the systemic importance of a financial institution ought to result in weaker fines, lighter regulatory treatment, or fewer criminal repercussions from breaking the law. The simple adage: you do the crime, you pay the time (or fine), should prevail. To do otherwise is to prove the premise supporting the argument of TBTJ. This should be a position that both the break-up-the-banks and-let-the-market-judge-size camps should agree.

TBTF is comprised of two distinct questions:

1) Can a financial institution be so large that its size alone distorts markets, the rule of law, creates moral hazard, and threatens financial stability: Too Big?

2) Is there an institution that is so systemically important that its failure would create broad financial instability, or start or exacerbate a financial panic: To Fail.

While there is disagreement about how to answer the Too Big question, there is broad agreement that To Fail must be solved. As the Bipartisan Policy Center’s Too Big To Fail report put it:

“Regardless of one’s view on whether banks are too big for other reasons, there must be a solution that allows the largest firms to fail without risking a collapse of the financial system or needing a government bailout.”

While there is disagreement about how to answer the Too Big question, there is broad agreement that To Fail must be solved.

Post financial crisis, the world set about to tackle the To Fail problem. In the U. S., the Dodd-Frank Wall Act put in place a series of new regimes to solve the problem. Those provisions include “living wills” for banks before they get in trouble, orderly liquidation authority for regulators should those banks fail, contingent capital to avoid government bailouts, and prohibitions against providing financial assistance to any single failing institution, to prevent moral hazard. As Treasury Secretary Jack Lew said, “as a matter of law, they state clearly that no financial institution is ‘too big to fail.’”

Similar rules were put in place globally, and while the details differ, the basic aim was the same: to create an environment in which the failure of a systemically important financial institution would not cause a financial crisis. Switzerland has taken substantial measures to increase capital reserves for its largest financial institutions, leading its financial regulator to boast that: “Here Switzerland is taking the lead.” In that same press release, they indicated that substantial progress had been made so Switzerland: “now ensures that the continuance of systemically important functions in a crisis will be guaranteed by 2019 at the latest.” Given that success it is ironic that their regulatory body should be claiming any systemic rationale or even weighing in at all on what the appropriate fine for past misconduct should be.

American policy makers should arrive at two fundamental conclusions, which should be clearly articulated: When wrong-doings occur, the size and scope of the penalty will be proportional to the crime and the laws and regulations governing that crime. An institution’s financial size, interconnectedness, or other systemically important functions should not factor in to any decisions on punishment – and should be true for all financial firms, foreign and domestic.

Second, the U.S. expects other countries to apply their rules similarly to our firms who are engaged internationally. There should be no domestic preference in punishment either in the U.S. or abroad. While there have been multiple substantial fines for U.S. banks’ illicit activities, there should be consistency of punishment as a result of actions — not where headquarters are located.

Coming to this conclusion does not imply agreement that the current punishment structure is correct. It is not clear that we have made the right policy choices when considering and applying the appropriateness of jail time for culpable employees and officers of financial institutions. Although massive by past standards, the fines for conduct during the financial crisis have not, by and large, resulted in greater public belief that banks suffered appropriate consequences. Nor is it clear that the fines individual institutions have agreed to have been appropriately sized. Additionally, policy makers should reconsider when liability should transfer from a financial institution when it is acquired by another, especially when that transfer is assisted or encouraged by the government.

One of the definitions of the word chutzpa is when a child kills their parents and then asks the court for mercy because they are an orphan. Accepting the argument from the Swiss or from any domestic bank that their systemic nature should result in softer punishment is indeed chutzpa. If policy makers expressly or de facto change punishment as a result of concerns about a financial institution’s systemic nature or location of headquarters, we will have lost the battle against Too-Big-To-Jail, which would create the need to fundamentally change the legal structures put in place regarding Too-Big-To-Fail. That would be a major mistake. Now is the moment to make sure that we do not go down that path.