Big Bad Bank and Little Red Trustbuster

by Chidem Kurdas

A surprising new Small-Is-Beautiful movement is afoot.  Mario Rizzo, Jerry O’Driscoll, Harry Kaufman and others make a case for  breaking up too-big-to-fail financial institutions. As Mr. Kaufman puts it, otherwise those companies will become financial public utilities backstopped by the government.

It’s not likely that the 2008 crisis would have been prevented had top investment banks like Goldman Sachs been smaller. Traditional little banks are going down in droves. They fail because real estate loans are going bad. So many depository banks have gone under that the FDIC, the federal agency that insures deposits, itself ran out of money and asked to be bailed out by prepayment of bank premiums.

The same real estate bubble-and-bust hit larger banks through mortgage-backed securities. That’s regardless of size. Moreover, the government does not just bail out big investment banks. It bailed plenty of small savings & loan associations in the 1980s. The concept of “too-big-to-fail” is remarkably elastic.  Consider that GM and Chrysler both received federal aid. Chrysler is a lot smaller, but the political preference is to treat it as too-big-to-fail. Keeping banks relatively small will not stop such bailouts.

That said, there is a serious quandary.

Mr. O’Driscoll points out that “the size and complexity of the major financial firms do not reflect market forces but public policies.” The government won’t let big banks go under; knowing this financial companies become big and make risky bets; since their failure may wreck havoc, taxpayers are forced to bail them out.

As Russell Roberts wrote, “If the taxpayer almost always eats the losses for the losers, you don’t have capitalism. You have crony capitalism.” Is the solution anti-trust action against the big banks?

Trust-busting may sound like the right step after a Great Crisis. But there is no real anti-trust case. The so-called bulge bracket banks are the ones you see in the headlines, but medium and small – often called ‘boutique” – investment banks are significant enough to attract many people from the big league.

Each line of business that makes up investment banking, from brokerage to trading, is subject to ferocious competition. Bank trading desks, for instance, compete with thousands of hedge funds.

So reducing the size of investment banks on the ground that they rely on government backstopping would be a new type of intervention and a major expansion of regulatory authority. This is not any less of an intervention than other kinds of regulation being bandied about. You’re not tackling monopoly power but moral hazard.  Why not stop creating moral hazard?

But let’s take it that the government can’t – or won’t – stop creating moral hazard for big institutions. What to do? Gary Becker suggested  imposing a higher capital requirement for larger banks. He wrote in March; “implement a progressive set of capital requirements relative to assets that would increase as the size of a bank or other financial firm increased.”

This automatic rule has the great advantage that it limits regulators’ discretion. It is certainly better than arbitrary interventions dictated by lobbyists, although somebody would have to decide how much to increase the capital requirement and at what levels of  bank assets.

Last week Senator Chris Dodd introduced an alternative to a financial regulation bill backed by the administration. Among other measures, Mr. Dodd would require large companies to draft emergency plans for orderly shutdown in case of insolvency.  If they fail to provide “funeral plans” they may face greater capital requirements, restrictions on growth and forced sale of risky businesses.

A clear, transparent rule of progressive capital requirements is the best idea so far.  Mr. Becker’s proposal certainly merits greater attention.

But it will not prevent future crises as long as the Federal Reserve blows asset bubbles and politicians encourage the giving of mortgages to the less credit-worthy. I suppose fiddling with banks is easier than confronting that reality.

15 thoughts on “Big Bad Bank and Little Red Trustbuster

  1. To clarify my position. I agree that “as long as the Federal Reserve blows asset bubbles” and the government pursues policies encouraging risk taking, there will be moral hazard and excessive risk taking. The first best solution is to end these policies.

    But the premise of Kaufman’s piece, which I endorse, is that the government cannot credibley commit to not bail our the largest institutions (time inconsistency). As long as there is a Fed, it cannot credibley commit not to blow bubbles.

    Contrary to the suggestion of the first sentence, I did not endorse “breaking up” large institutions and later described using antitrust law as a hamfisted approach. I endorsed Becker’s approach (which is not original to him) of progressive capital requirements as the best of the second best solutions offered thus far. I am open to others.

    I am worried, but less so, about smaller institutions because they are easier to resolve and the government is increasingly showing a willingness to close them down. I was gratified by the decision to let CIT go down with $2.3 billion of TARP money wiped out. That signals that boutique invetsment banks would be allowed to fail.

    I await the second coming of the free market; the return of free banking; the abolition of the 16th Amendment (and perhaps also the 17th, as some have suggested); and the restoration of the Privileges or Immunities Clause of the 14th Amendment.

    Until then, what do we do about too-big-too fail?

  2. Jerry, I mostly agree with your comments. My point about smaller investment banks is that there is no case for antitrust action, which is one of the ideas making the rounds. The point should be to do no harm–admittedly a dictum that is oft violated in its original medical context and certainly in policy making. In seeking solutions for too-big-to-fail, You don’t want to create other problems, right?

  3. My preference for what we’ll call the Becker proposal – progressive capital requirements – is that it mimics a market outcome. Before FDIC insurance, bailouts, too-big-to-fail, etc., banks held much higher capital ratios. George Kaufman did the research and I recall ratios like 25%. We have a long way to go before we need to start fretting about “too much safety.”

  4. Becker had it on his March 9th on blog post; that’s when I saw it & thought it’s a promising possibility. I’m perfectly happy to recognize other people’s claim to the idea.

  5. Just saw that yesterday an alternative amendment was proposed for Barney Frank’s financial bill, adding a new chapter to the bankruptcy code for streamlined bankruptcy when there are failures of large, non-bank institutions. Commenting on the amendment, Rep. Shelley Moore Capito (W. Virginia) says there should be no more bail-outs and no too-big-to-fail. The amendment I believe is backed by the industry. I’m not a bankruptcy expert. Is this a reasonable solution?

  6. I haven’t seen the amendment. I favor going through the bankruptcy code. Sen. Dodd wants to bypass bankruptcy and Peter Wallison explained why that would be a bad idea in yesterday’s Wall Street Journal.

    I first heard Becker articulate the idea during a luncheon speech in NYC at the Mont Pelerin Society meetings. That would have been the weekend before that blog post. It is useful to have his support for he idea. I don’t know who first came up with it.

  7. The bankruptcy process can go on interminably for financial firms. Shortening and simplifying it would certainly make it much easier to contain the damage from a large failure, hence undercutting the “too-big-to-fail” rationale for bailouts.

  8. Thanks for the information & insights, Jerry. It is an important and multi-faceted topic. I think a discussion like this, with give-and-take of ideas, helps clarify the issues. It’s especially relevant now, with Congressional hearings going on.

  9. Today’s WSJ reports: “Sen. Sam Brownback (R,, Kan.) said he supports an idea that is increasingly finding converts on Capitol Hill: allowing the government to preemptively break up large firms.” I’m not sure what these people mean by “preemptively break up”.

  10. I think it is not a bad idea to have stricter competition laws of banks. Most of this policy is probably old and does not take into account globalized markets. Then it was about a bank to have a certain share in one market such as the US. In nower days this bank may have this share in every market in the world. Then a collapse has much greater implications. Maybe banks should also not hold each others stocks.
    I am not sure about this issue but obviously a bank crash can bring about much more damage than some large industrial firm. Generally regulation to assure more competition and allow the market process to work more efficient is not a bad idea. Another point would be to rid of entry barriers and allow for more competition on this way. Maybe this would be efficient by itself.

  11. Each of the lines of business that make up investment banking is highly contested. Overall this is a fairly competitive industry–though the current consolidation and government actions will probably reduce the competition.

    It would seem that the issue isn’t really competition or lack thereof.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s