The Fed’s Lame Defense of Too Big To Fail

Washington’s Blog
Tuesday, Nov 10th, 2009

Federal Reserve Governor Daniel Tarullo argues that we should not break up the too big to fails or reimpose Glass-Steagall because:

Financial institutions that experienced so many problems — such as Bear Stearns and Lehman Brothers, which did not have commercial banking operations — would still have posed a “too big to fail” threat had commercial banks been prohibited from owning investment banks prior to the crisis.

He also said that commercial banks without investment-banking issues have, in the past, had serious difficulties as well. “Some very large institutions have in the past encountered serious difficulties through risky lending alone.”

That’s like arguing that nuclear power plants shouldn’t be regulated as to how close they are to earthquake faults because some plants failed because their concrete containment dome wasn’t thick enough.

Giant banks become dangerous to the entire economy if one or more of the following occur:

(1) They are too big;

(2) They speculate too much, especially if they are speculating with deposits gained through normal depository banking functions (the whole dynamic Glass-Steagall was enacted to stop); or

(3) They focus too much of their investments in credit default swaps or other instruments which allow massive looting.

Nuclear plants must be sited away from earthquake faults and their containment domes have to be thick enough. Similarly, all 3 of the giant banks problems must be addressed. The TBTFs should be broken up (see this and this). Glass-Steagall should be reimposed. And risky investments which encourage looting and which generally destabilize the system should be reined in.

Note: Sure, higher capital and liquidity requirements – as suggested by Tarullo – would be helpful. But unless the real core risks are addressed, they won’t be nearly enough.

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