Financial Innovation leads to big banks that pose major risks

. Accessed 6/25/24.] LT

At the height of its power, in the run-up to the crisis of 2008, much of the influence of the financial sector was based on the fact that bankers were thought to be smart. “Financial innovation” was believed by many policy makers to be just as profound and just as conducive to productivity growth as the steam engine or the telephone had been in the nineteenth century. Under the approving eye of regulators, big banks were allowed to become larger—and to take risks that were bigger relative to their balance sheets. As a result of the financial-innovation-based boom and the crisis, the remaining big financial firms became bigger and remain very powerful politically. At the end of the fourth quarter of 2010, the six largest U.S. bank holding companies had assets valued at just over $9 trillion, which was 63% of gross domestic product (GDP). This is up from around 55% of GDP before the crisis (e.g., 2006) and no more than 17% of GDP in 1995. In the mid-1990s today’s six largest banks had assets around 20% of all banks insured by the Federal Deposit Insurance Corporation (FDIC). Today the size of these same banks, measured in the same way, is up to about 60%. At least roughly, this gives an indication of how the largest banks have risen in importance to the overall financial system—partly because of how financial innovation has played out. With assets ranging from around $800 billion to nearly $2.5 trillion, these bank holding companies are perceived by the market as “too big to fail,” meaning that they are implicitly backed by the full faith and credit of the U.S. government. They can borrow more cheaply than their competitors and hence become larger. Despite reform efforts since the crisis, including the Dodd-Frank legislation, big banks today still pose major structural system risks. Neil Barofsky, the special inspector general for the Troubled Assets Relief Program (TARP) summarized the situation well in his January 2011 report, emphasizing “perhaps TARP’s most significant legacy, the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail’” (SIGTARP 2011, 5). In public statements, top executives in these very large banks discuss their plans for further global expansion—presumably increasing their assets further while continuing to be highly leveraged. The next set of proposed innovations appears to be intensely cross-border in nature. There may be important and significant risks associated with these expansions. A very large cross-border bank liquidation cannot be handled through ordinary bankruptcy or through the currently operating resolution mechanisms (see the discussion below). Nevertheless, this global banking strategy is endorsed or at least supported in public by senior leadership at the Treasury Department (Scheiber 2011).