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Sunday, February 12, 2012

"Break Up the Banks? Here’s an Alternative"

Tyler Cowen says there's no need to break up big banks or impose lots and lots of regulations to ensure they can't take excessive risks with other people's money, making shareholders responsible for bank losses would fix the problems:

Break Up the Banks? Here’s an Alternative, by Tyler Cowen, Commentary, NY Times: Bailing out financial institutions deemed “too big to fail” has become wildly unpopular, as people across the political spectrum are now talking about splitting up America’s large banks. But such breakups are probably not the best way forward, because they would penalize size instead of failure. ...
So the logic of cutting down huge institutions could mean splitting the largest ones into several pieces. Yet banks do not always come in easily divisible parts. Such a move could amount to eradicating the largest banks rather than splitting them up — and eradication is both politically unlikely and potentially disastrous for the economy. In short, if the resulting parts of a divided bank cannot turn a profit, the split-up may prompt the very bailout it was trying to avoid.
Another fear is that American money market operations would move to larger foreign banks, which would have a newly found competitive advantage. ...
There is still another problem. The more a bank is legally limited in terms of easily measurable size, the more it may resort to off-balance-sheet activities to make up the difference. “Breaking up big banks” may really mean making these less-transparent bank activities much more important to a bank’s fate.
Maybe tough new rules for off-balance-sheet activities could limit this problem, but the overall history of financial regulation belies that view. ...
There is a better alternative: expanding the liability for major financial institutions. If a shareholder invests a dollar in a big bank, why not make that shareholder liable for the first $1.50 — or more — of losses as insolvency approaches? In essence, we would be making the shareholders liable for the costs that bank failures impose on society, and making the banks sort out the right mixes of activities and risks. ...
This proposal would shrink the financial sector, while avoiding excess regulatory micromanagement of bank activities. But it could still be combined with other regulations, like limits on leverage, if deemed appropriate or necessary.
Unlike the “big is bad” view, this proposal would penalize failing banks rather than safe, successful ones that happen to be large. ...
We need to resist vengeful or “feel good” options for financial reform and embrace those that will really work.

Some notes: First, there's an implicit assumption in this article about the minimum efficient scale for a bank. Tyler worries that breaking up banks will result in less efficient banking operations (i.e. higher cost) causing the smaller banks to fail altogether, or be less competitive with foreign banks.

However, I have not seen convincing evidence that banks need to be as large as they are for efficiency reasons (here's some evidence, but as I noted, I am not convinced by it). I am not advocating a per se rule here -- we shouldn't break them up just because. But if there's evidence that the size leads to undue political or economic power that is being exploited in the banks' favor, and if mega-mega-size is not necessary for efficiency, then there is definitely a reason to break them into smaller pieces. From my perspective, there is quite a bit of evidence that these banks have far too much political influence, and I think a case can also be made that it's unhealthy for the economy to have firms with such a large market share in particular segments of financial markets.

So I think that, absent of strong evidence that there actually are economic efficiencies associated with size (in which case they ought to be treated more like a regulated monopoly than a competitive marketplace), and the evidence that these banks are highly influential politically -- to the point where regulatory capture is more than a passing worry -- we should break these banks into pieces that are closer to the "minimum efficient scale" for financial institutions. I think the minimum is much smaller than current size, but once again, if that's not true then we need to treat these banks more natural monopolies (or natural bilateral monopolies, trilateral monopolies, or too small of a number to be competitive industries).

But we shouldn't fool ourselves into thinking that breaking up big banks into smaller pieces will necessarily make the financial system more stable. We had bank runs and financial meltdowns in eras where there were predominately small banks, think of the Great Depression for example. That's because it's the interconnectedness of banks that causes the problems, and smaller banks can be just as interconnected and hence just as vulnerable to a systemic shock as large banks. Perhaps there's a bit more diversification in larger banks that offers some protection, but the evidence is not strong on this point and big banks appear to be just as vulnerable as small banks to systemic troubles (and vice versa).

The stability of the system has more to do with regulatory restrictions, e.g. controlling the risks that shadow banks can take, or with economic mechanisms of the type Tyler is calling for that get the incentives for financial firms to take risk correct, than it does the size of institutions. I am not as confident as Tyler is that his scheme will work -- I am more inclined to pursue the regulatory route -- but in any case the problem of how to enhance the stability of the financial system is not about the size of banks as much as it's about interconnectedness and the degree to which financial firms can take risks without facing the full consequences of their decisions.

One final note: It seems to me that given the lack of transparency in the financial system -- the inability of investors to monitor the risks that banks are taking with the money they invest, and the lack of solutions such as reliable ratings agencies that help to overcome this informational disadvantage -- making investors liable for even more than they actually invest in a bank would kill the incentive for average or even above average investors to put money into this industry (and the ability of shareholders to monitor corporations even when informational problems are much less severe appears to be problematic). If finance and large banks are as critical to the economy as Tyler claims, does he really want to take the chance of causing investors to shy away from this industry to the point where their willingness to invest falls short of what is optimal given full knowledge of the risks they face? On this score, I think the traditional banking sector approach of providing some form of depositor guarantee coupled with limits on risks that banks can take and insurance premiums to cover depositor losses and limit moral hazard is a better approach. There are difficulties with providing depositor guarantees in the shadow banking system, but as Morgan Ricks argues, there are ways to over come this problem (Gorton and Metrick also have a proposal involving improving the collateral banks hold as insurance against depositor losses).

But whatever we do, we need to get on with it. Despite the Dodd-Frank financial reform bill and its directive to address this issue, the problem of bank runs in the shadow system -- a key factor in the financial sector collapse -- has not yet been solved. Work on this is underway, and new reulations are in the works, but for now the problem has not yet been resolved.

    Posted by on Sunday, February 12, 2012 at 12:49 PM in Economics, Financial System, Regulation | Permalink  Comments (46)


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