Monday, October 21, 2013

Is It In Our Interest to Break Up Big Banks? Why the Notion of "Too Big to Fail" Is Too Damaging

The systemic nature of the Great Recession has made it the worst economic downturn since the Great Depression. The causal mechanisms of the recession are multifaceted and more interconnected than I care for. The government-sponsored entities known as Fannie and Freddie, regulations from the Department of Housing and Urban Development (HUD), as well as the Community Reinvestment Act of 1995, exerted pressure on banks to make taking out a housing loan much easier for low-income and middle-class families, which artificially increased the demand for home ownership. Aside from predatory lending, banks used securitization to re-package different combinations of credit-quality mortgages to better hide and evade the costs of subprime loans. Structured investment vehicles made it difficult for credit risk agencies to accurately rate loans. The Federal Reserve kept the federal funds rate low, which is problematic because artificially low interest rates come with adverse consequences, including excessive borrowing and risk-taking. In addition to an increasingly materialistic society, consumers thought that they could borrow at such low rates without consequences, and thus racked up a ton of consumer debt (see consumer debt to GDP ratio). To summarize the South Park episode Margaritaville, "there is plenty of blame to go around."

Since the Great Recession, there has been a call for dealing with banks that are "too big to fail (TBTF)." Many would like to see these big banks broken up into smaller banks so that we can avoid another calamity like the Great Recession. I'm no fan of Big Banks getting into bed with Big Government and receiving special treatment and favors, but is breaking up big banks the proper move?

What makes a bank too big to fail? We do not know if the banking system would have come apart had we not bailed out the banks under the Troubled Assets Relief Program (TARP). The idea of TBTF might be a plausible theory, but it's still only a theory that has yet to be substantiated. What makes a bank TBTF is based on what regulators believe to be too big, which in the case of Dodd-Frank, is $50B in assets. By that regulation, the Federal Reserve is too big to fail. Given that the GDP is over $15T, I highly doubt that a bank with $50B would bring a collapse of the financial system, especially since the banking system make up a smaller portion of the GDP than other developed nations. Plus, how does one determine whether a bank will be TBTF down the road? What size does a bank need to be for a regulatory institution not to meddle?

I have to wonder if anyone thought of the implications of actually breaking up a big bank. Trillions of dollars pass through the global markets each day. If one breaks the larger banks up, would a smaller bank be able to efficiently handle all of those transactions? Operations simply would not be the same. What would happen to the risk-managment systems that deal with interest rate swaps or currency swaps? They would be diminished. Also, downsizing banks would affect downsizing operations, which means it would affect the one million-plus jobs in banking, and this does not even get into hypothetical transition costs.

If a bank is TBTF, there is a good chance that a bank is also too big to properly regulate. The government's legislative response was to pass Dodd-Frank, which was a bill of over 800 pages and came with 13,000 pages of regulations. This regulatory overhaul puts smaller banks at a competitive disadvantage because they do not have the same resources to ensure compliance with the regulations. Breaking up the banks would put the banking industry at an even larger disadvantage because none of the banks could handle the regulatory overload.

The consumer would also feel the cost of breaking up big banks because of the economic advantage of larger banks. The joy of larger banks is that they use the economies of scale by spreading the costs of infrastructure, technology, and other capital investments diffusely over a larger base, which means these banks can cut the cost of banking, as well as expand the scope of services rendered. Breaking up the banks would sacrifice valuable efficiencies by limiting the extent of the bank's services while increasing costs.  

The notion of TBTF only perpetuates the bailout mentality that creates moral hazard (see here and here) and a contagion effect. Reducing bank size does not solve the issue, as someone as Paul Krugman points out. Smaller banks have failed in the past, as we saw both in the Great Recession, Great Depression, and the Savings and Loan Crisis. Just look at MF Global, Bear Stearns, or Knight Capital.  What matters is the interconnectedness that financial institutions experience, regardless of a financial institution's size. The collusion between Big Banking and Big Government needs to stop, that much is for certain. But what can be done to help prevent the past from repeating itself? Bankruptcy laws (or even laws governing shadow banking) can be reformed, e.g., "living wills," to make sure that these firms can fail without causing breakdown of the economy. Alternatively, we can implement stricter capital requirements, higher reserve requirements, or we can even implement a contingent convertible debt requirement. However, to say that we need to break up big banks, especially without knowing what breaking up banks would trigger or even define how big a bank should be, is not a solution. In short, we need to abandon the idea of "too big to fail."

3 comments:

  1. Even beside "too big to fail" there is also "too big to hold accountable" and "too big and therefore holding far too much economic power with no accountability."

    A smaller bank would require less regulation, since any stupid or illegal activities would have smaller consequences. This is why my wallet is unregulated: I'm too small to matter.

    "Breaking up the banks would put the banking industry at an even larger disadvantage because none of the banks could handle the regulatory overload. "
    Again, less regulation would be needed, and even if the same level were used, everyone would be in the same boat. Besides, smaller banks would hopefully have the good sense to focus their operations more and therefore be subject to fewer regulations.

    "Also, downsizing banks would affect downsizing operations, which means it would affect the one million-plus jobs in banking"
    So? Let's never weep for useless jobs.

    "However, to say that we need to break up big banks, especially without knowing what breaking up banks would trigger or even define how big a bank should be, is not a solution."
    A general concept is never a solution, but to say that an idea must be discarded entirely merely because it has not been fully developed is absurd. All ideas start out poorly-conceived and only by giving them serious consideration to they develop, as opposed to aborting any idea that doesn't spring forth fully-formed and ready to implement.

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    1. In response to your comments, Andrew:

      "Even beside 'too big to fail' there is also 'too big to hold accountable' and 'too big and therefore holding far too much economic power with no accountability.'"

      That could theoretically be the case, but in reality, not so much. For example, the indictment of Arthur Andersen about a decade ago resulted in 28,000 jobs lost and a sullied reputation. Even right now, JP Morgan is going to pay $13 billion on a settlement and could very well be facing criminal charges, so no, not really.

      "A smaller bank would require less regulation, since any stupid or illegal activities would have smaller consequences."

      Whether I like it or not, Dodd-Frank is law, and because of the ratchet effect, even if you broke up the banks, its here to stay. All it would do is put every single bank at the mercy of onerous, burdensome regulations.

      "This is why my wallet is unregulated: I'm too small to matter."

      You and your wallet are not too small to be regulated. It's called taxation.

      "So [what if we downsize their operations]? Let's never weep for useless jobs."

      Amazing how you'd want to sacrifice significant economic growth for smaller banks. Smaller banks wouldn't have the infrastructure, labor, or capital to handle the larger transactions that take place in the financial world on a daily basis. It has a larger implication than what you label "useless jobs," and I'm curious to why you'd think their jobs are useless, aside from a bias against larger banks. I didn't think you'd take such a misstep here, but if we're going to talk about useless jobs, why don't we take a look at government inefficiencies since the government has a knack for it? Arguably, the sequester didn't go far enough in getting rid of useless jobs. At least I'd know the money coming from my regulated wallet, as well as the regulated wallet of others, if we actually cleaned house and made the government leaner.

      "A general concept is never a solution, but to say that an idea must be discarded entirely merely because it has not been fully developed is absurd. All ideas start out poorly-conceived and only by giving them serious consideration to they develop, as opposed to aborting any idea that doesn't spring forth fully-formed and ready to implement."

      It would be absurdity to discard it merely for that reason, but as I already illustrated in my blog in great detail, I'm not discarding it as such. If we want to talk absurdity, it would be to have confidence in a policy without empirical evidence, without even doing a cost-benefit, or hammering out a detail as simple as "How big should a bank be" without it being arbitrary (which wouldn't be the first time the government acted in such a way). Public policy is much like mathematics: there are more wrong answers than right ones. This is no exception. Not only are banks a vital part of the economy, but the larger banks make multiple, international financial transactions on a daily basis. Breaking up the banks would have ramifications well beyond our borders. If you want to start a nasty domino effect, then sure, let's break up these banks. Alternatively, we can come up something else to put in failsafes to make sure the 2007-2008 recession doesn't repeat itself while avoiding more shocks to the financial system. I prefer the latter, but hey, that's me.

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    2. Correction on comment:

      "At least I'd know the money coming from my regulated wallet, as well as the regulated wallets of others, would be put to better use if we actually cleaned house and made the government leaner."

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