In testimony today in front of the Senate Banking Committee, newly installed Federal Reserve Chair Janet Yellen faced questioning from Massachusetts Senator Elizabeth Warren on the issue that has been dogging financial regulators since the financial crisis: can the country's largest banks fail without taking down the economy or requiring massive government assistance to keep them afloat?
Elizabeth Warren, who's known for her tough questioning of financial regulators and economic policy officials asked Yellen, "what evidence do you need to see to declare with confidence that 'too big to fail' has ended?"
The question comes more than three years since the Dodd-Frank bill was signed, which was supposed to institute new rules that would make banks less risky and put in place a procedure whereby regulators could resolve a failing megabank without bailing out its lenders and shareholders. Since the financial crisis, the six largest banks, which all received some level of government support, have only grown in size. The largest banks received hundreds of billions of direct investments and cheap loans from the federal government during the financial crisis to help keep them afloat.
Despite much of the bill having come into force, most regulators and experts doubt that "too big to fail" is really over — a few weeks ago, Daniel Tarullo, the member of the Federal Reserve Board of Governors in charge of regulation and bank supervision said that more needed to be done to reduce the risk of massive bailouts.
Yellen said that no one would know if a megabank like JPMorgan or Citi could survive a collapse without risking the health of the entire economy, "until it's been tested in some way." She pointed to likely future efforts by the Fed that would erode any implicit subsidy for a megabank, including making it more expensive for the largest banks to maintain a large level of assets, assessing what's known as a capital surcharge.
The logic behind such a policy would be to erode the advantage the largest banks get from their lenders because of the perception that they will be bailed out by the government if they run into trouble. Many proponents of stricter bank regulation say that such an advantage, which could be as much as $83 billion a year, is functionally a subsidy that flows directly to only the largest and most dangerous banks.
"So long as the markets believe that 'too big to fail' has not ended," Warren said, "do we still have a 'too big to fail' problem?"
"The markets may think that we will rescue such an institution and may not end up believing us until we put it through resolution," Yellen responded, "so we can't guarantee that they an appropriate view of how we'll handle such a situation."