Why Big Banks Should Be Smaller

James Kwak wants to make US financial institutions smaller:

There are a few main things that made companies like AIG and Citigroup systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities...
Size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities).

Kevin Drum is not convinced:

It still has the flavor of a solution that's clear, simple, and wrong. After all, Bear Stearns was a quarter the size of Citigroup, and it was considered too big to fail. So just what would the limit be on bank size? $500 billion in assets? $200 billion? Can a country the size of the United States even have nationwide banks with limits like that? And what happens the next time around, when all these smallish banks overleverage themselves and collapse en masse? Are we any better off than we are with a few big banks failing?

I'm with James on this one. Two things are worth noting about Bear Stearns: first, it might have been small by Citigroup standards, but its balance sheet was still enormous. And secondly, it wasn't considered too big to fail, it was considered too interconnected to fail, largely as a result of its role as a major CDS broker.

To get specific, I think that maybe $300 billion in assets would be a reasonable cap on bank size -- there's very little evidence that banks get any economies of scale beyond that in any case. If they want to be part of a global or even a national network that would be fine -- I'm sure such networks would spring up quite naturally, much as they have in the airline industry. After all, the United States managed to go 200 years without any nationwide banks, it's unclear why it desperately needs them now.

At the same time, the cap on the balance sheet of broker-dealers should be smaller still: the more interconnected you are, the lower the cap, to the point at which companies like the CME, which are far too interconnected to fail no matter how small their balance sheet, should be barred from issuing any liabilities at all.

As for what happens when lots of smallish banks overleverage themselves and collapse en masse, well, you get an S&L crisis. Which is fiscally painful, to be sure, but which can largely be avoided through good regulation and which more importantly doesn't have anything like the systemic implications of the current meltdown. So yes, we're better off with one of those than we would be with Citi and BofA both failing.

The problem is a practical one: how do we get there from here. There are no good and politically-feasible answers to that question. So in the real world, TBTF banks are here to stay. But that doesn't mean we have to like it.

Disclosure: No positions

Comments

[jstratt:]

I appreciate the authors perspective.

However the seperation between banks and brokerages seemed to work well for a long time. Also if a bank is so big that it has additional systemic risk, then perhaps it should pay a higher rate to the FDIC.

Given the critical role of banks in our economy perhaps they should be restricted from contributing $5 billion to our politicians. The money may overwhelm politicians and the risk is that a huge transfer of taxpayer money gets siphoned off.

Banks are important to our economy and need to be saved. We seem to have crossed the line however where it isnt convenient to allow anyone to fail. When the government steps in as it should, the bondholders dont get punished and poor management decisionmaking gets rewarded. All this seems to come at the expense of taxpayers.

Mar 30 04:32 PM

[William Arm...:]

Felix, there is a way to get there from here. Step one is to realize that the resolution of the current mess and how we regulate things going forward are two separate problems. In the current circumstances, we have no alternative but to keep the big institutions alive for now. With the passing of a little time,they will earn their way out of the problem, since banking margins are large during and after a crisis. Messy, but it is done all the time. Last time in the U.S. was during the Latin American Debt Crisis in the 1980s.

During this process, we monitor them closely, and require them to deleverage their on and off balance sheet assets. If we are strict about this, then soon we will see that they are no longer TBTF. This is effectively what is being done now.

Then going forward, we prevent this from happening ever again. And not with a Systemic Regulator. We tried that with Fannie and Freddy and it didn't work. You can't accurately measure systemic risk and the strict regulations put in place at the beginning will be "systematically" worn away by the constant pressure of the political process. Rather, we just go back to the kind of regulation that we had under Glass-Steagall, but with a difference to enable financial groups to be in all areas of the financial business. Keep the banks, insurance companies, and securities companies separate, but allow them to be owned by a holding company and apply strict single borrower limits or related party lending limits to keep one institution's problems from affecting the other.

It can work. We didn't get in the present mess because we lacked a systemic regulator. We got here because the politicians deliberately dismantled regulations that had served us well for many years.

Mar 30 06:45 PM

[John Slater:]

The primary issue is not simply bank size (though I am in agreement that giant banks are not healthy for the body politic), but the confusion of functions. We have mixed up the agency function of disintermediation, with the principal risk appetite of the banks. Per my post at mergers.com/toughtimes.../ Geithner is so focused on recreating the securitization engine that he is missing the major risk inherent in allowing giant deposit gathering institutions to take on principal risks in these volatile markets. That's a recipe for disaster as has been proven over and over again. It's an awful lot easier for a trader to stuff his bank's proprietary portfolio with unwanted junk than to do the hard job of finding unsuspecting widows and orphans to buy the drek.

Mar 30 10:35 PM

[Steven Hansen:]

you need to design the function of banks so that they do not fail in times of stress. banks must not be allowed to take risk. we cannot have this kind of systemic failure in the future.

and then there is the issue of size. no institution should be allowed to grow to a level where their failure endangers our economy.

Mar 31 12:55 AM