Too Big to Regulate: Systemically Dangerous Institutions – the U.S., Iceland, and Ireland

This column was prompted by Thomas Hoenig’s December 1, 2010 op ed in the New York Times (“Too Big to Succeed”) warning that we must end banks that are “too big to fail.”

Mr. Hoenig is the President of the Federal Reserve Bank of Kansas City, and I am a professor of economics and law at the University of Missouri-Kansas City, so the reader may suspect that my profound agreement with much of his reasoning is the product of rooting for the home team. I have held the same views on this issue, however, for decades (and I only moved here four years ago).

I will focus on the profound, negative consequences that the “systemically dangerous institutions” (SDIs) pose for effective financial regulation using the examples of the U.S., Ireland, and Iceland (so this is in part a follow-up on our recent discussions in Kilkenny, Ireland at the Kilkenomics Festival). I call these banks SDIs because “systemically important” is a dishonest euphemism. The administration claims that the failure of any U.S. SDI is likely to cause a systemic, global financial crisis. That means that they are dangerous.

The SDIs led the charge against effective financial regulation and supervision. They produced the repeal of the Glass-Steagall Act and the passage of the Commodities Modernization Act of 2000 (which placed credit default swaps into a regulatory black hole).

At the international level, the SDI led the travesty that was Basel II. The anti-regulators that administered the Basel II process decided to invite the SDIs into the standard-setting process – with predictable results. At the same time that the SDIs were massively increasing their risks, the Basel II standards substantially reduced their capital requirements, placed increased reliance on credit rating agencies, and encouraged banks to create models to value their own assets. The result was an enormous growth of SDI leverage, grotesquely inflated credit ratings for financial derivatives created and sold by the SDIs that were backed by pools of “liar’s” loans (toxic waste became “AAA”), and ludicrously inflated asset values at the SDIs. Bank leverage was even more extreme in Europe than in the U.S.

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