No Financial Institution Is Too Big to Fail, Mahoney Tells Congress

If Congress passes laws that allow the government to deem some financial institutions “too big to fail,” taxpayers will continue to bear the brunt when those institutions falter, Dean Paul G. Mahoney told lawmakers during a congressional hearing Tuesday on Capitol Hill.

Paul G. Mahoney“The identification of particular firms as too big to fail and, therefore, the beneficiaries of an implicit government guarantee, is a bad idea,” Mahoney told the U.S. House Committee on Financial Services. “It is not clear that the magnitude of the problem is sufficient to justify the scale of government intervention that we have seen in the past year.”

President Barack Obama’s administration has proposed handling “Tier 1 Financial Holding Companies,” or Tier 1 FHCs, to different regulatory and oversight standards. The administration has proposed creating a special resolution regime outside the normal bankruptcy process that would be triggered when the stability of the financial system is at risk.

“A credible threat that failure will lead to a resolution proceeding in which the marginal loss will fall on creditors, not taxpayers, will do a better job of disciplining risk-taking than the combination of oversight and an implicit government guarantee,” Mahoney told committee members.

Mahoney suggested allowing financial institutions to go through bankruptcy proceedings, so costs may be appropriately passed to creditors rather than taxpayers.

“The best way to reduce moral hazard is to ensure that economic agents bear the costs of their own mistakes,” he said.

Mahoney suggested that the banking crisis was not just a temporary liquidity problem, but a result of sharp declines in real estate and other asset values.

“A bailout can redistribute those losses to taxpayers, but it cannot avoid them,” he said.

Creditors ensured by the government would likely anticipate that they would be able to shift losses to taxpayers, and may not charge enough for the capital they provide. In turn, the financial institution would not pay a sufficient price for taking risks.

“The result is a dangerous feedback loop,” Mahoney said. “Large banks have access to cheap capital, which causes them to grow even larger and more systemically important while taking excessive risks, all of which increases the probability of a crisis.”

Mahoney argued that once a firm has been designated a Tier 1 FHC, other financial institutions will view it as having an implicit government guarantee, as they did for Fannie Mae and Freddie Mac. Risks transferred to Tier 1 FHCs “will be in effect transferred to the federal government.”

“Any institution that can keep its gains while transferring catastrophic losses to the government will find a way to engage in excessive risk-taking and expansion, and the financial system as a whole will suffer more frequent financial crises.”

The committee asked Mahoney to speak at the hearing, “Systemic Risk: Are Some Institutions Too Big to Fail and If So, What Should We Do About It?” Three committee staff members are Virginia Law graduates: Jim Clinger ’87, senior counsel; Thomas Duncan ’78, general counsel; and Adam Trost ’07, counsel.

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