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Financial Institutions Too Big to Fail

Sep 01, 2010 Brian Bradley

The economic crisis has exposed the imperfections of the financial system and the need for regulatory reform. Government and the financial experts are searching for solutions to improve the economic landscape and to fix the problems that have been revealed during these tumultuous times.

The imperfections of the financial system that have been uncovered is that it has become dominated by institutions that are "too big to fail" or as FDIC Chairman, Bill Isaac, puts it, they are "too big to manage, and too big to regulate."  Financial experts estimate that in the past 15 years the six largest U.S. banks have grown in total assets from 17 to 63 percent of the overall GDP. Their gigantic size and the perception in the marketplace that they are indeed too big for the government to allow them to fail, gives these megabanks a competitive advantage over smaller financial institutions. As a consequence some believe that this financial concentration of power must be reduced because it poses a great risk to the economy.

As a result the Brown-Kaufman amendment to the recently enacted financial regulatory overhaul, Dodd-Frank, has proposed a size cap on our largest banks.  This would restrict their assets to a very small fraction of the size of our economy. As Senator Edward E. Kaufman Jr., Democrat of Delaware, explained in a speech before the National Organization of Investment Professionals the idea would be that "by splitting up these megabanks, we by definition will make them smaller, safer and more manageable."

But what exactly does limiting the size of the largest financial institutions mean? The Brown-Kaufman amendment would cap the concentration of deposits held by any one bank at 10 percent of the nation's deposits, or about $750 billion. It would also put a cap on non-deposit liabilities at 2 percent of the U.S. GDP.   A statutory leverage requirement on banks and financial institutions would be imposed requiring them to hold a minimum of 6% of capital as a percentage of their overall assets. This rule will largely affect the big banks, such as Citigroup, Bank of America, and JPMorgan Chase, because they tend to hold less capital than small banks.

As expected, the proposal created a real debate and numerous controversies. Especially since the Riegle-Neal Banking Act of 1994 already established a 10% cap nationally on any particular bank’s share of federally-insured deposits.  In the years since then, large firms have obtained waivers or used loopholes in the law to exceed that ceiling.  But for now the large firms can continue on with their waivers and loopholes since in early May the Brown-Kaufman amendment failed to pass in the senate.