Rebecca J. Simmons writes,

The critical element of the SPOE strategy is the recapitalization of the company’s material operating subsidiaries with the resources of the parent company. For the SPOE top-down approach to work effectively, there must be sufficient resources at the holding company level to absorb all the losses of the firm, including losses sustained by the operating subsidiaries.

SPOE is being touted as the solution to the too-big-to-fail problem. You have a gigantic bank holding company that gets in trouble. You (the FDIC) want to keep all the subsidiaries going, because you want depositors and counterparties not to panic. So you put the holding company into receivership, and only pay off shareholders and debtholders of the holding company after your are sure you have got money to do that.

I may not fully understand this. Here is what I think happens. The value of the subsidiaries as ongoing concerns is positive, say $100. However, if you subtract the value of the outstanding debt of the holding company, the value of the holding company is negative. With, say, $150 in outstanding debt, the holding company’s value is -$50. The receivership creates a new holding company, which will eventually be sold back to the public, but without the outstanding debt. When the new holding company is sold, the debtholders in the old company get first dibs on the proceeds, and if there is anything after that, the equity holders can get it. Again, I could be completely wrong about this, but that is my understanding.

Simmons continues,

The capitalization of the bridge financial company must be sufficient…not only to allow the operating subsidiaries to obtain needed capital from the bridge to continue operations but also to allow stakeholders and the broader public to view the entity as safe and viable as it transitions from failed firm to bridge financial company, and ultimately to emergence as a new firm.

The problem is that financial firms have multiple self-fulfilling states of equilibrium. There is a state in which everyone believes in you, so you pay low interest rates on your debt, and you are fine. There is a state in which counterparties do not believe in you, so your interest costs soar, and you are dead. One key question about SPOE is whether it can prevent a jump from the good equilibrium to the bad equilibrium.

Suppose that we had this strategy in place, with all of the legal means for implementation. I still believe that if JP Morgan Chase or Citigroup got into trouble, the Fed Chairman and the Treasury Secretary would be wetting their pants. In a crisis, the probability that they would go through with SPOE, rather than undertake an ad hoc bailout, is very low.

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.

One possibility I am considering for this panel discussion is to give a spiel on how free-market economists have been more hawkish than mainstream economists when it comes to bank regulation. I was inspired by listening to Robert Litan recount some of the history at a talk last night on Trillion Dollar Economists. You may recall that may take on that book is that it has great material, but I would have liked to see different organization and emphasis. I was reading it with my high school economics students in mind.

Anyway, here is the spiel.

Long ago, two groups of free-market economists decided to “shadow” the Fed. The Shadow Open Market Committee, which I believe started in the 1970s, issued pronouncements critical of monetary policy. The Shadow Financial Regulatory Committee (SFRC) , issued pronouncements critical of regulatory policy starting in 1986.

The SFRC had both a deregulation agenda and a regulation agenda. Their deregulation agenda was mainstream. Observers of banking regulation across the political spectrum recognized that deposit interest ceilings were no longer workable, that the Glass-Steagall separation of banking and securities was no longer workable, and that prohibitions against interstate banking and branch banking were no longer workable. People had known since the late 1960s that those regulatory boats were sinking, and the laws that Congress passed in the 1980s were just the long-awaited permission to abandon ship.

Take Glass-Steagall, for example. In 1968, the distinction between a loan and a security was obliterated by GNMA. A few years later, the distinction between a deposit and a security was obliterated by money market funds. Even though some people try to blame the financial crisis on the repeal of Glass-Steagall, the fact is that it collapsed 20 years before it was repealed and nobody has said that you could bring it back.

It was the SFRC’s hawkish regulatory agenda that was out of the mainstream. In particular, if you read through its old statements, you will see that the SFRC issued many warnings that bank capital regulations were inadequate. They pleaded for tighter regulation of Freddie Mac and Fannnie Mae, for higher capital requirements for banks, and for regulators to require banks to have a thick layer of subordinated debt which would put the onus for failure on the private sector rather than the taxpayers. These calls went unheeded. The SFRC economists were viewed as cranks, whose judgment on these matters was impaired by an irrational distrust of government agencies.

Here is a chart, using the Google ngram tool, showing the frequency of the appearance of the term “financial supermarket” over time.

Note the spike in the mid-1980s. Given that these are books, which appear with a slight lag, I would say that the spike in the media was in the early 1980s.

At this panel, I don’t know whether I will have time to get into the history of bank concentration in the U.S., but here it is.

1. The market share of the largest banks follows a hockey stick pattern since 1950. It stayed very low until the late 1970s, and then around 1980 it started to grow exponentially. Growth of banks had been retarded by ceilings on deposit interest rates, branching restrictions, and Glass-Steagall restrictions. Banks had been trying to find loopholes and ways around these restrictions, and regulators had been trying to close the loopholes. Then, during the period 1979-1994, the regulators stopped trying to maintain the restrictions, and instead cooperated in ending them. That was when the hockey stick took off.

2. The regulators thought that this would bring more competition and consumer benefits. What the banks had in mind was something else. That is where the chart comes in. The bankers all thought that “cross-selling” and “one-stop shopping” would be killer strategies in consumer banking. In 1981, when Sears bought Dean Witter, many pundits thought that putting a brokerage firm inside a department store was going to be a total game-changer.

3. It turned out, though, that consumers did not flock to brokerage firms in department stores, or to any of the other one-stop-shopping experiments in financial services. The economies of scope just weren’t there.

4. Meanwhile, concentration in banking soared thanks to mergers and acquisitions. I’ve read that JP Morgan Chase is the product of 37 mergers and Bank of America is the product of 50. All of these took place within the past 35 years.

5. Just five years into this exponential growth process, Continental Illinois became insolvent, and that was when “too big to fail” began. So out of the 35 years where we were on the exponential part of the hockey stick, 30 of them have taken place under a “too big to fail” regime. In short, the concentration in banking got started during the “financial supermarket” bubble, and from then on was supported, if not propelled, by “too big to fail.” But the market share of the biggest banks is not something that grew naturally and organically out of superior business processes.

6. As another historical point, when the S&L crisis hit, the government set up the Resolution Trust Corporation. Each failing institution was divided into a “good bank” and a “bad bank,” with the good bank merged into another bank and the assets of the bad bank bought by the RTC. While this was a somewhat distasteful bailout, it was conducted under the rule of law. When TARP was enacted in 2008, Congress and the public were led to expect something similar to the RTC, with TARP used to buy “toxic assets” in a blind, neutral way. Instead they ended up calling the biggest banks into a room and “injecting” TARP funds into them. They also spent TARP funds on restructuring General Motors. It was the opposite of government acting in a predicable, law-governed way. It was Henry Paulson and Timothy Geithner making ad hoc, personal decisions. I think that in the U.S., that is what bank concentration leads to–arbitrary use of power. That is why as a libertarian I do not think that allowing banks to become too big to fail is desirable.