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's logic, 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."