Capping Bank Size

Includes: BAC, JPM
by: Felix Salmon

Simon Johnson joins in the chorus advocating a hard cap on bank size:

There is a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits. This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”

This cap was set at an arbitrary level — as part of the deal that relaxed most of the rules on interstate banking — and it worked well (until Bank of America received a waiver).

Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy. Of course, there are technical details to work out — including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would the benchmark around which all the specifics can be worked out.

What is the right number: 1 percent, 2 percent, or 5 percent of G.D.P.? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.

A hard cap at 4 percent of G.D.P. seems about right for a bank with the most conservative possible portfolio. This would mean no bank in our country would have no more than about $500 billion of liabilities, even with a relatively low risk portfolio. On a risk-adjusted basis, most investment banks would face a cap around 2 percent of GDP.

This is very much in line with the number of $300 billion which I pulled out of thin air in March: the key is to get a number, any number, and to make sure that any banks of that size are small enough to fail. Arbitrary rules are fine, just so long as they’re stuck with: we’re not trying to optimize the regulatory structure, we’re just trying to make it so that too-big-to-fail isn’t a systemically-devastating problem.

TED, however, still isn’t happy:

Mr. Johnson fails to mention what I consider to be an equally if not more important point: what financial leverage we will allow these institutions to maintain. It will do us no good whatsoever to have a bunch of globally interconnected $500 billion financial intermediaries if they are all levered 15-, 20-, or 30-to-1. At least in the subsector known as investment banking, one can make a strong argument that it was leverage which killed Bear Stearns and Lehman Brothers, not simply their sheer size.

This is true, but it’s a slightly different issue. The good thing about Simon’s use of liabilities is that it automatically includes a lot of the simplest leverage: the more you borrow, by definition, the more that your liabilities increase. The cap should I think be on contingent liabilities, and should try to recognize the use of embedded leverage as much as possible, with a principles-based approach which doesn’t allow banks to try to do an end-run around regulations by using off-balance-sheet vehicles and the like.

TED’s right, however, that we still need a leverage cap over and above the hard cap on liabilities: just because banks are small enough to fail, that doesn’t mean that we want many such banks all failing at the same time because they’re all small and over-leveraged. And capital ratios should be higher for big banks, with liabilities over $100 billion, than they are for smaller banks with lower leverage.

The problem, of course, is that all the distressed M&A over the course of the crisis means that US banks are bigger than ever — and that there are no plans at all for shrinking them. How would you even start taking behemoths like JP Morgan Chase (NYSE:JPM) or Bank of America Merrill Lynch (NYSE:BAC) and turning them into small-enough-to-fail institutions with a mere half-trillion in liabilities? It’s getting there from here which is the hard bit, and I haven’t seen anything which looks like a workable roadmap yet.