The Magazine

Too Big for Comfort

Why we need to break up the banks.

Jun 4, 2012, Vol. 17, No. 36 • By JAMES PETHOKOUKIS
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And a rational CEO of a key Wall Street player also knew that if he did make some cataclysmic mistake, Uncle Sam was there to cushion the landing. Indeed, the bigger the firm and the more enmeshed it was in the financial system, the more likely the government backstop would be there. The riskier banks were, paradoxically, the safer they were​—​at least for bondholders. So why wouldn’t “rational CEOs” try to increase their return on equity by lowering capital levels, increasing leverage, and finding new, profitable lines of business? They might be violating their duty to bank shareholders if they didn’t. “The consequence of expanding the safety net to an ever-increasing range of activities is to invite a repeat of our most recent crisis,” said Thomas Hoenig, vice chairman of FDIC and former president of the Kansas City Fed, in a speech last year.

But treating the financial crisis like a malaria outbreak uses the wrong model. Better, say the authors of that Fed bank study, to view the meltdown as a different sort of noneconomic catastrophe: “Science has a theory of why earthquakes occur, but quakes strike without warning, and there is nothing we can do to prevent them. Even so, policymakers can mitigate their consequences.” Or as Hayek might have put it, not only is government unable to predict the future, the world is too complicated for it to really have much useful understanding of what’s going on right now. Regulators are always a day late and a dollar short. Indeed, despite Dodd-Frank, the biggest banks still have a sizable funding edge over their smaller rivals. Markets still perceive them as too big to fail.

So how do you (a) make the financial system more shockproof when the next economic earthquake hits, (b) reduce the likelihood of expensive taxpayer bailouts, and (c) ensure the banks themselves don’t cause the next crisis? Hoenig, for one, would only allow banks to engage in traditional activities that are well understood and are based on long-term customer relationships so borrowers and lenders are on the same page: commercial banking, underwriting securities, and asset management services. Banks would be barred from broker-dealer activities, making markets in derivatives or securities, trading securities or derivatives for their own accounts or for customers, and sponsoring hedge funds or private equity funds. The result would be banks that are smaller, simpler, safer. Not only would they be less likely to spark financial crisis because management would know government might let them fail, the cost of failure to taxpayers would be less.

Of course, some will argue that we need large, complex financial institutions and that their very existence is proof of that. Who are the know-it-all breaker-uppers to say we don’t? But that size and complexity is itself more a result of crony capitalism than of market forces. It’s little wonder, then, that the preponderance of the evidence is that all the supposed benefits from supersized banks and their economies of scale are outweighed by the risks of disaster they generate. Take this 2011 study from the University of Minnesota: “Our calculations indicate that the cost to the economy as a whole due to increased systemic risk is of an order of magnitude larger than the potential benefits due to any economies of scale when banks are allowed to be large. .  .  . This suggests that the link between TBTF banks and financial crises needs to be broken. One way to achieve that is to break the largest banks into much smaller pieces.”

 There are other options, of course. We could just put a hard cap on bank size. But there’s no clear evidence what that size limit should be. Besides, while the failure of a big bank creates a big economic impact, it’s not necessarily size that makes a bank potentially dangerous as much as what a bank does. Others want to treat systemic risk as an externality like pollution and tax it. Nothing wrong with that in theory. Former presidential candidate Jon Huntsman proposed just such a plan and would have used the revenue to cut corporate taxes. The riskier the activities the bank engages in, the higher the tax. But this again requires too much knowledge on the part of regulators to precisely gauge the riskiness of activities or assets and levy an appropriate tax. Again, Hayek. A risk tax also creates new opportunities for Wall Street lobbying.

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