Why Banks Remain Too Big to Fail

SMITH BRAIN TRUST — Told big bank failure would trigger a flood of bankruptcies and economic calamity, U.S. taxpayers collectively paid billions of dollars to bail out large institutions from the 2008 financial crisis. Despite passing Dodd-Frank legislation to mitigate a future bailout, Congress is on the verge of amending the U.S. bankruptcy code to make bankruptcy feasible for larger banks — more so than when Lehman Brothers’s 2008 bankruptcy filing ignited widespread panic.  

The new legislation would give regulators and judges more authority and means to fix and stabilize a bank that’s failing. It also means big banks remain too big to fail. But why? “The issues surrounding this problem still exist in one form or the other despite the most comprehensive legislation affecting the banking sector since the Great Depression,” says Professor of the Practice Clifford Rossi at the University of Maryland’s Robert H. Smith School of Business. “Firm complexity and inter-connectivity; issues that led to systemic risk for the financial sector, remain today.” 

Rossi, who’s held senior executive roles in risk management at several of the largest financial services companies, says the largest banks still maintain massive balance sheets with a wide range of complex assets and liabilities that pose a great deal of risk to these firms and the industry in general. “Risks are ever present and require enormous focus and — more importantly — for companies that manage risk well,” he says. “These risks can come from rogue trading as in the JP Morgan Chase London Whale event, credit and trading risks, from political risks as evidenced by the recent Brexit vote and cyber attacks from unfriendly governments or criminal elements.”

Regarding the latter, hackers are increasingly targeting financial institutions. The Wall Street Journal reports this week more than 43 percent of breaches at banks and other financial firms in the first half of 2016 were caused by hacks or malicious software, up from 27 percent for all of 2015.

Rossi adds that it’s “very likely the housing and mortgage bubble would have been a nonevent had firms prior to the financial crisis embraced a culture of risk management.” Such a culture, he says, “is marked by strong corporate governance practices at the highest corporate levels, executive compensation plans aligned with shareholder interests, a long-term view of risk-taking and balanced risk-return management.”

“Instilling strong risk governance across organizations and imposing stronger risk-based capital standards keys to ensuring our largest financial institutions do not become wards of the state,” Rossi says. “Care must be taken, however, not to overregulate as this can have deleterious consequences for the industry and overall economy.”

Assessing Risk in Strategic Planning

In his recent Risk Doctor column at American Banker, Rossi advises banking managers to approach risk with a "what can go wrong" approach — beyond assessing potential successes and failures of everyday operations. This is significant in the face of such factors as “relatively poor earnings growth, nonbank competition and intense regulation increasingly threatening the core business model of banking these days,” he writes. “Some of these realities have warranted bank management to weigh transformational changes to compensate a new product, an M&A deal or new pricing, to name just a few examples.” Read more here.