This article was originally published in The New York 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.
In light of the financial chaos after Lehman Brothers’ collapse in 2008, companies of its size are now often considered too big to fail. Yet before its collapse, Lehman had a capitalization of about $60 billion, compared with the $143 billion capitalization of JPMorgan Chase last week.
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. If a financial problem arose, we would either bail out the foreign banks or rely on a foreign central bank to protect our own interests. Neither option seems appealing.
Even if a breakup went well, the incentives for the new, smaller banks would be unhealthy. Those banks could make mistakes or take on bad risks without being punished very much in terms of capitalization or revenue, because of their legally capped size. Even if they made big mistakes, these banks would probably be pushing on the frontier of maximum allowed growth. Eventually, the competitive process would cease to make these banks tougher or smarter or leaner, and we would just be cultivating another kind of banking system where bad or irresponsible decisions don’t lead to financial failure.
Most important bank failures spring from correlated risks, like the bursting of a real estate bubble, that affect many banks at roughly the same time. Bailing out a large number of smaller failing banks may be easier than bailing out a smaller number of large ones, since it is easier to apply bankruptcy and the procedures of the Federal Deposit Insurance Corporation to the smaller institutions. But that outcome hardly gets rid of bailouts.
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. Banks are usually wealthier, nimbler and smarter than their regulators, at least when it comes to finding loopholes in the regulations or making their moves more opaque. In any case, splitting up major banks also requires that regulators get some other significant decisions right.
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. Eugene N. White, an economics professor at Rutgers University, supported a related proposal in a recent paper, “Rethinking the Regulation of Banking: Choices or Incentives?”
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. That’s also more in accord with the American ethos of winning at business.
Under this reform, it’s quite possible that we would end up with some very large and also relatively safe banks. Note that Canada, whose banking system has proved remarkably safe over the last century, relies on a small number of major banks.
In any case, the market can adjust bank sizes over time, as perceived risks to banks change, without requiring new legislation to ward off each new source of risk. It’s hard for the law to win that race, especially when Congress is so fractious.
Expanded liability for bank shareholders might satisfy the Occupy Wall Street movement, and could be sold as a market-oriented, not regulatory solution; it’s probably what markets would insist upon if there were no central bank and no F.D.I.C. As recently as the 1980s, the partnership structure, another alternative to limited liability, was common among investment banks — and that hardly seemed a crippling drawback at the time.
We need to resist vengeful or “feel good” options for financial reform and embrace those that will really work.