12/20/2012 02:43 pm ET Updated Feb 19, 2013

Wake-Up Call on Financial Reform

The HSBC money-laundering settlement demonstrates conclusively that the Dodd-Frank reforms have not ended the so-called "Too-Big-to-Fail" problem. The outrage about HSBC getting off so lightly has been too narrowly focused. This should trigger reform of all the systemically dangerous banks.

HSBC admitted to extensive involvement in helping major drug dealers launder huge amounts of money. Why wasn't HSBC prosecuted for these crimes? Because the government was afraid that indicting them would set off a chain of events that would cause the failure of the bank and that this would lead to a financial crisis. Assistant Attorney General Lanny Breuer said that "We don't want to make a decision that is going to have all kinds of horrible collateral consequences."

In other words, HSBC was able to avoid prosecution by holding the US economy hostage. The same logic was used to justify the 2008-09 bailout programs that put trillions of dollars into megabanks and other huge institutions to stave off a depression. AIG explicitly cited such a threat when they were arguing for the second infusion of billions of dollars from the government.

Companies whose failure can cause economic crisis are often called "Too Big to Fail" but that is a misnomer. Big isn't the problem. We have lots of big companies that aren't a risk to the economy. The distinguishing feature of these companies is that they are so complex and interconnected that they threaten the financial system. So, let's call them what they are: "Systemically Threatening Institutions" or STIs.

Why do we need to have institutions whose failure could have horrible consequences. Some argue that we need big banks to serve the needs of global corporations. But, empirical studies find that these benefits are fully realized at asset sizes much smaller than the current megabanks.

Rather than being more efficient, their size and complexity makes them unmanageable. Just in the past year we have seen that STIs are unable to prevent uncontrolled hedges, rogue trading and money-laundering.

What's more, STIs' business model has moved away from serving productive businesses and toward derivatives trading. According to the latest report from the Office of the Comptroller of the Currency, 6 large US banks have less than 50% of total bank assets but 98% of OTC derivatives positions and 99.6% of the credit default swaps (CDS) held by all US banks. Bank involvement in derivatives markets brings them into a web of interlocking obligations, transmitting financial distress from one institution to another. AIG was bailed out specifically because of the threat they posed to the global banks due to the credit default swaps that bound them together.

Even in normal times, systemically threatening institutions have pernicious effects. The perception that major financial institutions cannot be allowed to fail undermines market discipline and regulatory oversight as well.

In a well-functioning market, the risks banks take are constrained by their ability to borrow on reasonable terms. If a bank is complex, highly leveraged and opaque lenders pull back and this provides a valuable brake on their risk-taking. However, if those lenders are confident they will be protected by the government, as they were in 2008, then they no longer scrutinize the bank's credit. Just as people rely on FDIC insurance, large institutions rely on the ability of the STIs to coerce a bailout. So, market discipline is gone.

What's more, STIs actually have an incentive to take risk. The implicit government guarantee is, in financial terms, a free put option. That option is worth more, the riskier the company is. And, the bigger and more interconnected they are, the more sure they are of being bailed out.

The other ostensible protection against excessive risk-taking is regulatory oversight. But, the STIs' size undermines that as well. The megabanks have enormous political power. Many regulators either formerly worked at the big banks or may hope to in the future. Both experience and logic make it clear that it is extremely foolhardy to put great faith in regulation to keep these banks from taking excessive risks.

Dodd-Frank was supposed to have fixed this problem. The regulators were given authority to put these banks into receivership. But, market participants are very skeptical this is feasible. Apparently the Departments of Justice and Treasury are as well.

There is wide agreement about what needs to be done - shrink, simplify, break them up. Bring them to the point that they are not systemically threatening and can be allowed to fail. The banks' derivative use needs to be limited and they need to return to their essential functions of lending and providing financial services to people and productive enterprises.

There are many sound approaches to accomplish this. Federal Reserve officials including Governor Daniel Tarullo and NY Fed President William Dudley have made proposals to simplify the banks. Republican Senator David Vitter and Democratic Senator Sherrod Brown have called for higher capital requirements. Even former Citigroup CEOs John Reed and Sandy Weill have called for a return of Glass-Steagall. Many more have endorsed similar ideas. The only dissenters seem to be the most central players on Wall Street and in Washington.

Nearly four years ago, Treasury Secretary Geithner said "To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game." He was right. Unfortunately, the HSBC settlement shows that the Dodd-Frank act has not done enough. We urgently need true reform to abolish systemically threatening institutions.