Can Too Big to Fail Actually be Kept from Failure?

An article in this morning’s Financial Times quotes Bill Dudley, the New York Federal Chief.  His concern is there may be ‘significant gaps’ in the central bank’s ability to provide emergency funds to help financial institutions in difficulties.  He wants to allow broader access to the Fed’s lending window. 

At a Fed function in Amelia Island, Florida Dudley stated, “In my view, an important issue is to identify and address gaps in the Fed’s lender-of-last-resort function.”  His concern is that only depository institutions like commercial banks have access to the Fed’s discount window, which is a source of emergency loans during a crisis.  “The law hampers the ability of a bank to pass along discount window funding to its securities unit” explains The Wall Street Journal. 

Dudley went further, “Now that all major securities firms in the U.S. are part of bank holding companies and are subjected to enhanced prudential standards as well as capital and liquidity stress tests, providing these firms with access to the discount window might be worth exploring.” 

I have blogged in the past about concerns I have with the sheer size of derivative holdings of banks.  US Banks held credit default swaps at a level of $60 trillion on the eve of the 2008 financial crisis.  This level was far greater than the volume of cash obligations it was insuring.  The real problem with the derivatives comes in a crisis when the counterparties are not able to fulfill their obligations on the contract.  Warren Buffet has called derivatives a financial weapon of mass destruction.

So fast forward to 2015.  For the first 9 months of 2015, derivative trading produced over $41 billion in revenue for our nation’s banks and holding companies.  This represents nearly half of the revenue earned by the holding company.  Clearly, there is a profit motive for these instruments.  At the end of September 2015, US banks held $192 trillion of derivatives, most of these being in the form of interest rate swaps.  The top five banks—JP Morgan Chase, Citibank, Goldman Sachs, Bank of America, and Wells Fargo, held $180 trillion at this time.  This amount is way more than the $6.4 trillion in assets held by the institutions and also much larger than their capital base.  This amount also dwarfs the GDP of the US, which was around $18 trillion in 2015 and the GDP of the entire world, which is around $75 trillion.  Sounds like another case of the “too big to fail” syndrome.

One who is skeptical might consider if such a move by the Fed would free up the trading units in these banks to take even bigger risks with more leverage, knowing that if things go haywire, the parent bank can always run to the discount window for a quick fix.  Smells like the seeds for another crisis are being sown.  Good thing that the credit union industry has not jumped onto the derivative bandwagon as we have seen with banks. 

Another banking story today comes as the biggest banks think they now have a constitutional right to risk free profit from the Fed.  In December, Congress took some of the Federal Reserve’s accounts to fund a new highway bill.  This was done by cutting the annual dividend on stock that big banks purchase to belong to the Federal Reserve System.  The stock is risk free, the dividend gets paid out even if a regional Federal Reserve Bank were to be disbanded. 

The dividend rate is also lucrative to the banks.  If a bank has over $10 billion in assets, the dividend was 6%.  Now the new legislation cut the rate to the yield on a 10 year Treasury note.  At the last auction this was 1.765%.

So the American Bankers Association claims this is not right.  Their claim is that the dividend rate has been the same for the past century and it was considered essential to the Fed to attract member banks.  Really, banks are required to join the Federal Reserve System.  This is from the Fed’s formation back in 1913.  Besides there are other benefits to banks to being a member such as access to the discount window. 

The ABA further claims that the “takings clause of the Fifth Amendment provides that private property shall not be taken for public use without just compensation.”  So the ABA believes the 6% dividend rate itself is constitutionally protected since it is bank property and has been around for a century.  The ABA’s comments came last week prior to the end of the public comment period on the dividend cut.  Look for a lawsuit next.  So in the meantime, will the new highway bill be funded?