William Armstrong

Why Big Banks Should Be Smaller

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.

The Debate over Banking Reform, Part 2

I fully agree. The TBTF box is not a home. It is a place where a financial institution would go temporarily where the authorities could keep a good eye on it while it takes actions to reduce its size and riskiness. If it is so far gone that it cannot be rehabilitated, then the box is a place to conduct an orderly liquidation.

Once the rules of the regulatory regime that I describe are applied and understood, I believe that very few institutions would end up tripping the wire to be declared TBTF, since the consequences of going to the penalty box would substantially wipe out the shareholders.

The Debate over Banking Reform

While it is possible that some "trust-busting" will be necessary I don't think overt size is the problem now. Remember, the de-leveraging is for real. Financial institutions have fewer risks on their books (and, importantly, off their books) than before and they may have fallen in size below the threshold of what used to be considered too big to fail.

I will be publishing an article that touches on this tomorrow.


On Mar 22 02:04 PM John Lounsbury wrote:

> I have been waiting for your take on the banking situation. Thanks
> for publishing at a most opportune time.
>
> My emotional side tells me that "trust busting" is needed. My logical
> side tells me that super large financial structures are needed to
> coordinate the global economy. I depend on those with a lifetime
> experience in banking (especially international banking), such as
> you, to lay out the pros and cons of various proposals.