1. I am worried that breaking up the biggest banks would not make the system safer.
I do not believe that having smaller banks would have prevented the 2008 crisis or the next crisis. I do not believe that regulatory policy can prevent such crises. My only solution for systemic financial risk is to try to make the financial system easier to fix when it does break. I think it is easier to fix when there is less debt, so I would look for ways to reduce incentive to take on debt. Instead of subsidies for mortgage borrowing, how about subsidies for down-payment saving? Instead of favorable tax treatment for debt, why not favor equity–or at least be neutral between the two? etc.
For me, breaking up the banks is not a safety issue. It is instead an issue of restoring democracy and the rule of law. Really big banks are crony banks, whose interactions with government officials are at the highest levels. Instead, I would like to see the biggest banks dealt with by career civil servants who are following clear, predictable rules and guidelines.
2. I am worried that it would be difficult to define size.
Once you decide that banks above a certain size should be broken up, you need a definition of size. Among the problems with doing this, the first one that comes to my mind is accounting for derivatives. If you ignore derivatives, then in very short order banks will mutate their loan portfolios into derivative books. But if you try to include derivatives, then the whole notional-value vs. market-value argument is going to kick in. Also, gross exposure vs. net exposure.
Instead, I am attracted to using the amount of insured deposits as a measure of size. It is a clean measure that cannot be gamed using accounting transactions. It is a measure of the potential impact of the bank on the FDIC. Charging a risk premium that is graduated by size would be a reasonable rule-of-law approach to discouraging large banks. Banks could avoid the risk premium by spinning off branches. The giants that were assembled by mergers could be dis-assembled by spin-offs.
3. I am worried about large shadow banks.
You can do a lot of banking without a lot of deposits. You can finance with commercial paper. You can finance with repo. You can write a ton of derivatives. I do not think that this is bad per se. But, just as with large commercial banks, large shadow banks could acquire the political power of large commercial banks.
I welcome suggestions for dealing with shadow banking. I am not thinking about how to reduce the risk of shadow banking. My view is that systemic risk is systemic risk, and you cannot get rid of it by breaking up banks.
What I am concerned with is the political power that might be concentrated in a large financial institution. The problem is that, once you get away from deposits, measuring “large” becomes quite tricky.
What about just eliminating governmental deposit insurance?
Taper off, of course !
All fair. I invite a counter-proof to the following Worry Conjecture:
Worry Conjecture: It is not possible for an economy to experience better than minimal rates of real growth and improvements to real standards of living without the risk of, and occasional actuality of, financial crises. Over the long term, the size and disruptions associated with crises will be loosely related to the amount of real growth per capita above minimal level.
Implication: If the above conjecture is true, meaningful real growth in living standards, especially for the population as a whole, imply a requirement for a periodic great recession or great depression.
If that is so, not only is there no mechanism to avoid crises (point 1. above) but in the end, making things easier to fix (also point 1. above) may be impossible.
[I really am looking forward to proofs that this is wrong.]
One thing I wonder is how fancy of financing we really benefit from. I see that deposits are helpful, as are plain old loans. How much do derivatives really add, compared to, say, buying stock in a bank that you think is making smart choices? More precisely, *which* derivatives are all that important?
In short, it would not be crazy to simplify the industry so that effective regulation is more tractable to draft.
Always puzzled when people suggest smaller banks would fix things. The behavior of banks tends to herd – significantly. A bunch of small banks all doing the same (risky) thing is no different than one large bank doing it.
May I suggest you write a book on banking.
Excellent posts today. This one led me to your earlier work – I wondered why you didn’t mention bank equity ratios under #1 as a measure to reduce debt, so I searched your blog for Hellwig & Admati and saw your (unfavorable) review from 2/26/13. As a comment on that review, I struggled with the idea that higher bank equity requirements would act against household preferences (if I understood you correctly). Another way of thinking about this would be:
Total deposits held by the public are determined by banks’ lending & balance sheet decisions + the Fed – not as a preference expressed by households. Or, you can think of deposits as a by-product of supply & demand in the markets for bank loans & other debt securities held by banks.
The fact that the time-to-demand deposit ratio rises over time may be a good indication that households wouldn’t otherwise ask for as many deposits as banks & the Fed create through loan markets and their balance sheet decisions. (More deposits find their way into time deposits over time because people don’t want the demand deposits but the money has nowhere else to go besides into time deposits – the public can’t make much of a dent in total currency + deposits except by paying down loans.)
There’s also the fact that the FDIC exists to make sure that the demand for deposits vs. currency is always high enough (even when banks are insolvent) to meet the supply that’s created through bank lending & debt security markets.
On the other hand, the public can decide whether to buy bank equity or not, or at least force the price of bank stocks down until supply meets demand. If stock prices are so low that banks don’t raise as much capital as they’d like and restrict their lending, then maybe those extra loans shouldn’t be made in the first place.
I like that you’re looking for unintended consequences and probably need to think about it more, but I guess I’m seeing different consequences when I look at the supply & demand for deposits vs. equity, role of FDIC + bank capital regs, etc.
Effem wrote:
Actually it is different. Ten smaller banks will have less political pull than one bank ten times as large. The reduced likelihood of a bailout will encourage creditors to pay more attention to banks’ soundness. It might not be a panacea, but it would be a step in the right direction.
Where are the new entries into the banking industry? Are VC firms now nurturing small but innovative banks? I realize that there are barriers (of scale) to entry, but no one even seems to be trying.
Hugh:
There are a myriad of “new” entrants into the financial system. The subset of the financial system classified as Real Estate Investment Trusts (REITS) expanded greatly – both in number and size – during and after the 2008 financial crisis. There also has been a fairly substantial recent growth seen in the number and size of financial firms classified as Business Development Companies (BDC’s). And there is emerging interest and growth in “micro-lenders” recently.
Those may not be considered “banks” in the commonly understood definition, but they provide the exact same function as “banks”, only in more specialized form.
Arnold:
While I agree – at least in principle – with the vast majority of what you and others have been saying and writing over the past few days on this topic, I fear many are suffering from “target fixation”. And the sole “target” seems to be the “big banks”, and worse, the sole remedies seem to be in some form of regulating/controlling/minimizing/penalizing “big banks”. While that may be satisfying for those who fear the banks, or would like to see revenge exacted from banks, or whatever other like justification, I can’t help suspecting that the “remedies” for “big banks” are quite detrimental to the much larger and more significant U.S. and even global economies.
The recent Brookings episode in which you participated – and your related posts – provides ample example. The discussion was fairly interesting. Their published paper was not – as my comments to your “Remembering the Suits vs. Geeks Divide” post of 10/29 describes. Simply adding more regulation to the U.S. financial system is detrimental to the economy. It’s (“inestimably”) expensive and everyone pays. And it is not proven to be better – just “inestimably” more expensive.
I would rather see and hear discussions on these topics proceed from a larger perspective:
1.) The U.S. economy (and larger global economy) is a large, complex, beneficial, and very robust thing. In order for it to be beneficial, it requires a large, robust and probably equally complex financial system.
2.) Ultimately, the sole function of that financial system – how it is of benefit to economies – is to provide an agency function – acting as agents representing those who have undeployed money (shareholders/investors, creditors, depositors), and making those undeployed funds available to those who wish to deploy those monies (borrowers).
3.) To a greater extent than nearly any other beneficial economic industry, the financial system exists within, and is defined by, it’s regulatory framework – which primarily includes more general contracts regulations. Again, the financial system is an agency function.
4.) Defining/designing a regulatory framework for the financial system – or any other industry – must always be driven, controlled and governed by the principle that regulation must first and foremost have the goal of decreasing transaction costs.
It may be arguable that the pre-existing (prior to 2008) financial system regulatory framework merely allowed transaction costs to “hide and build”, eventually resulting in financial system failure. (I personally don’t “buy” that argument, by the way.) But it is indefensible to argue that the current/proposed financial system regulatory framework will do anything but increase transaction costs to the economy, let alone preclude “hiding and building” again in the future.
I’m a tad skeptical breaking up large banks would really do much to eliminate crony capitalism. Trade groups like the American Bankers Association would probably just fill the gap. I suppose at the very least, regulators would have less need to be deferential to any one company, at least in theory.
Why not have a sliding scale of capital requirements based on size, funding sources, and activities (retail, commercial, IB etc)? I think David Einhorn proposed this…
Seems straightforward, if you want to be big you have to be boring or well/overly capitalized…
I think your comment ” I think it is easier to fix when there is less debt, so I would look for ways to reduce incentive to take on debt” is dead on right. I’m partial to the Minsky/Keen point of view that financial crises happen due to too much debt becoming insolvent at once. There needs to be a way to control the amount of debt outstanding at any given time and to have some sort of fire break to prevent a wider debt contagion. FDIC and the lender of last resort were old school fire breaks.
For #3, introduce FDIC like insurance for shadow banking. I believe Gary Gorton has pushed for this. Then you can measure size by amount insured and charge a risk premium to discourage size.
Obviously there are a lot of details left out of the above three sentences that might turn out not to be workable or ineffective.