The financial institutions deemed too big to fail were at the epicenter of the 2007–09 financial crisis. Previously thought of as islands of safety in a sea of risk, they became the enablers of a financial tsunami.

Now that the storm has subsided, we submit that they are a key reason accommodative monetary policy and government policies have failed to adequately affect the economic recovery.

Put simply, sick banks don’t lend. Sick—seriously undercapitalised—megabanks stopped their lending and capital market activities during the crisis and economic recovery. They brought economic growth to a standstill and spread their sickness to the rest of the banking system.

The Dodd–Frank Act has not done enough to corral ‘Too big to fail’ (TBTF) banks and that, on balance, the act has made things worse, not better. Parts of Dodd–Frank have exacerbated weak economic growth by increasing regulatory uncertainty in key sectors of the US economy. Despite its good intention, it has been counterproductive, working against solving the core problem it seeks to address.

Let me define what we mean when we speak of TBTF. The Dallas Fed’s definition is financial firms whose owners, managers and customers believe themselves to be exempt from the processes of bankruptcy and creative destruction. Such firms capture the financial upside of their actions but largely avoid payment—bankruptcy and closure—for actions gone wrong, in violation of one of the basic tenets of market capitalism. Such firms enjoy subsidies relative to their non-TBTF competitors. They are thus more likely to take greater risks in search of profits, protected by the presumption that bankruptcy is a highly unlikely outcome.

The phenomenon of TBTF is the result of an implicit but widely taken-for-granted government-sanctioned policy of coming to the aid of the owners, managers and creditors of a financial institution deemed to be so large, interconnected and/or complex that its failure could substantially damage the financial system. By reducing a TBTF firm’s exposure to losses from excessive risk taking, such policies undermine the discipline that market forces normally assert on management decision-making.

The reduction of market discipline has been further eroded by implicit extensions of the federal safety net beyond commercial banks to their non-bank affiliates.

Moreover, industry consolidation, fostered by subsidised growth (and during the crisis, encouraged by the federal government in the acquisitions of Merrill Lynch, Bear Stearns, Washington Mutual and Wachovia), has perpetuated and enlarged the weight of financial firms deemed TBTF. This reduces competition in lending.

Though the growingly complex reporting failed to prevent detection of the seeds of the debacle of 2007–09, Dodd–Frank has layered on copious amounts of new complexity. The legislation has 16 titles and runs 848 pages. It spawns litter upon litter of regulations: More than 8,800 pages of regulations have already been proposed, and the process is not yet done. Haldane notes that a survey of the Federal Register showed that complying with these new rules would require 2,260,631 labour hours each year. He added: “Of course, the costs of this regulatory edifice would be considered small if they delivered even modestimprovements to regulators’ ability to avert future crises.” And he concludes: “Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. [The situation] requires a regulatory response grounded in simplicity, not complexity. Delivering that would require an about-turn.”

The Dallas Fed’s proposal offers an ‘about-turn’ and a way to mend the flaws in Dodd–Frank. Our proposal would relieve small banks of some unnecessary burdens arising from Dodd–Frank that unfairly penalise them. Our proposal would effectively level the playing field for all banking organisations in the country and provide the best protection for taxpaying citizens.

In a nutshell, we recommend that TBTF financial institutions be restructured into multiple business entities. Only the resulting downsized commercial banking operations—and not shadow banking affiliates or the parent company—would benefit from the safety net of federal deposit insurance and access to the Federal Reserve’s discount window.

. As of third quarter 2012, there were approximately 5,600 commercial banking organisations in the US. The bulk of these—roughly 5,500—were community banks with assets of less than $10 billion. These community-focused organisations accounted for 98.6 per cent of all banks but only 12 per cent of total industry assets.

Another group numbering nearly 70 banking organisations—with assets of between $10 billion and $250 billion—accounted for 1.2 per cent of banks, while controlling 19 per cent of industry assets. The remaining group, the megabanks—with assets of between $250 billion and $2.3 trillion—was made up of a mere 12 institutions. These dozen behemoths accounted for roughly 0.2 per cent of all banks, but they held 69 per cent of industry assets.

The 12 institutions that presently account for 69 per cent of total industry assets are candidates to be considered TBTF because of the threat they could pose to the financial system and the economy should one or more of them get into trouble. By contrast, should any of the other 99.8 per cent of banking institutions get into trouble, the matter most likely would be settled with private-sector ownership changes and minimal governmental intervention.-

How and why does this work for 99.8 per cent but not the other 0.2 per cent?

To answer this question, it helps to consider the sources of regulatory and market discipline imposed on each of the three groups of banks.

Let’s look at two dimensions of regulatory discipline: Potential closure of the institution and the effectiveness of supervisory pressure on bank management practices.

Do the owners and managers of a banking institution operate with the belief that their institution is subject to a bankruptcy process that works reasonably quickly to transfer ownership and control to another banking entity or entities? Is there a group of interested and involved shareholders that can exert a restraining force on franchise-threatening risk taking by the bank’s top management team? Can management be replaced and ownership value wiped out? Is the firm controlled de facto by its owners, or instead effectively management-controlled? In addition, we ask: To what extent do uninsured creditors of the banking entity impose risk-management discipline on management?

Extract from speech of Chairman Dallas Reserves Mr Richard W. Fisher at the Committee of the Republic