I agree with Kevin Drum:
But to me it still has the flavor of a solution that's clear,
simple, and wrong. After all, Bear Stearns was a quarter the size of
Citigroup, and it was considered too big to fail. So just what would
the limit be on bank size? $500 billion in assets? $200 billion? Can
a country the size of the United States even have nationwide banks with
limits like that? And what happens the next time around, when all
these smallish banks overleverage themselves and collapse en masse?
Are we any better off than we are with a few big banks failing?
The whole post is worth reading, but I have a feeling that nostalgia
for the 70s just isn't going to work. Big companies are here to stay,
and I suspect that any regulation stringent enough to keep banks small
enough to fail won't be sustainable. And unless we reign in
overleverage and massive waves of credit expansion, it won't do any
good anyway. The same thing will happen again, just in a slightly
different way.
Here is my earlier post on itty bitty banks.
The answer seems pretty obvious: more stringent requirements for bigger banks. The bigger the exposure to the government, the less risk they are allowed to bear.
I’m an absolute amateur for all things economic, and I know I’m taking a big risk replying before I’ve had my morning coffee, but still I can see two major problems with the snippet from Kevin Drum.
First is his phrase “And what happens the next time around, when all these smallish banks overleverage themselves and collapse en masse?”. To me, this is equivalent to a discussion about designing a submarine – wherein the subject of compartmentalization is on the table – where Kevin, not a fan of hatches & seals, asks “what happens if all the compartments have a leak at the same time!?”. This question is a diversion from the design goal of keeping banks small. Presumably separate management teams could only make identically bad choices with low probability.
Second is his phrase “I suspect that any regulation stringent enough to keep banks small enough to fail…” Again, it seems like the design goal here is not to keep them so small that they can’t fail, but rather to assume that failure is inevitable and to limit the scope of the damage when it happens. The way that he phrased these things seems disingenuous to me. I can’t be some kind of economic genius to understand what the proposal is trying to achieve where you and he can not.
Maybe I’m missing something obvious, but I’d like to suggest a thought experiment: imagine a fantasy world where the only means of constructing a power generation plant would lead to a facility that might explode with some small probability. This frustrated the people who lived there. While only a few people got hurt, they had to keep rebuilding power generation plants.
Imagine that it appeared to the people who lived in this world that they could reduce the probability of explosion by building them larger. For a while, things seemed to go well. But one day they discovered that, while the probability of an individual power plant exploding was much lower if it were larger, the resulting explosion was geometrically larger: in the megaton range.
In a tradeoff between a local nuisance and a global catastrophe, I’d take the local nuisance. But that’s just me.
Fine, keeping banks small isn’t the (part of a?) solution. What is? Is EFP (above) correct? Is excessive FDIC insurance partly to blame? Is mortgage securitization to blame? Should the eviscerated bits of Glass Steagall be relegislated? Is a compensation mechanism that rewards short-term gain while ignoring systemic risk partly to blame? Should derivatives be regulated?
What would your priorities be if you were in charge of preventing future systemic risk? You are wonderful with numbered lists. Give us a list of priorities!
I was off this opinion until I started reading Simon Johnson, who makes the point the smaller banks=smaller profits, which leads to lower compensated, less powerful banking execs which make it harder for regulatory capture to occur. His Atlantic article does a nice job describing this.
I wonder if small banks could handle the risk involved with foreign currency trading.
I also wonder how we are going to create new, large companies without large banks to provide financing. Or are we going to drift back to having an investment bank/commercial bank divide? Why stop there? Banks should only deal with small companies. Let’s bring back and S&L for actual consumers.
Is it now truly hopeless to expect those who, like Drum, write professionally on public affairs to know that the phrase is “rein in,” as one reins in a horse, and not the ridiculous “reign in?”
The mistake is grating, to my eye at least, like the use of “dependant” for “dependent,” and the equivalent error on other words with the same ending.
“Simon Johnson, who makes the point the smaller banks=smaller profits, which leads to lower compensated, less powerful banking execs … ”
Perfect.
It seems like it would be useful to ask what the unintended consequences of size regulation would be. Just like the current crisis was partially fueled by gaming capital requirements, someone smart would probably figure out how to reduce bank size while increasing risk.
Regulation is the answer, not size. Consider something even much smaller than Bear Stearns: LTCM. While LTCM’s balance sheet was tiny, it very well might have spread contagion quickly around the financial sector. Meanwhile something much larger, such as Circuit City, can go bankrupt without a ripple, even though commercial bond holders lost billions.
The reason is LTCM, and later all investment banks, leveraged themselves to engage in speculative trading. The end source of that leverage was typically an investor who did not see losses as a possibility. Whenever the end investor sees no, or extremely little, downside risk, there must consequently be regulation to prevent that downside risk. Otherwise, panics will ensue at some point, somewhere once leveraged get giddy about something. A panic would have happened in 1999 if we invested in Tech stocks as we invested in housing 2001-05.
Remember “decoupling”? It was the fanciful notion that the global economy was more stable because more countries, with presumably varying situations, were involved? I agree with anonymous that the S&L crisis shows that “smaller is better” isn’t better. The lobbying power is still there, it’s just a bit more indirect. The “none too big” idea seems analogously flawed.
I agree with mickslam that the key issue is leverage. Each important panic/crisis has been accompanied by excess leverage. If we limit that, aren’t we already most of the way home?
I include consumer leverage in the picture. We continue to make home loans with 3% down, which is 33:1 leverage. Even if home prices weren’t continuing to fall, putting these mortgages under water a few months after they’re written, thereby multiplying the default risk, letting individuals lever up like that is part of the problem.
What does a successful bank look like as it approaches some arbitrary cap on size, employees, assets under management, complexity, etc. ? Do they start turning business away? Raise their prices and increase margins (while sending business away)? Spin off and sell off business units? Some of these measures might not be in the best interest of consumers.
It would be well to contrive a fair system that allowed small and regional banks a level playing field. Same with every business not TBTF. As our system descends more blatantly into fraudulence and patronism, our betters don’t seem overly concerned about those who they consider, “too small to care.”
Comments on this entry are closed.