Itty bitty banks

That's Paul Volcker's idea, namely that the way to prevent "too big to fail" is to prevent "too big."  Details are sketchy but Matt Yglesias offers some comments

Is there a precedent for this kind of plan working?  We have antitrust law but antitrust law doesn't actually prevent big firms from becoming big; we've had General Motors, Microsoft, Google, and others, all very large relative to their sectors.

You could imagine an absolute cap on the size of bank assets, so that above the size limit would-be loans and deposits are sent to a rival institution elsewhere by mandate.  One implication is that banks won't have to treat their customers very well, since in a growing economy (we'll get one again, sooner or later) a lot of banks will be at the cap and will be turning away extra business.  If different banks were perfect substitutes for each other, you wouldn't be seeing large banks in the first place.

A second question is whether ten little banks are safer than one larger, 10x bank.  For sure they are if the problem is one bonehead manager at the bigger bank, but what if it's systemic asset price risk?  The smaller banks could well be less safe.  In a financial crisis, would you rather be a larger country or a smaller country?

I believe the plan would require very tight restrictions on off-balance sheet activity.  Something like this may be coming anyway, and its rationale is understandable, but it is easier said than done.  We would be requiring regulators to estimate the net "size" (it's debatable whether that word even applies; what is the "size" of a naked put?) of a bank financial position when banks themselves haven't been very good at doing that.  A simple approach would be to ban all bank trading in derivatives but I believe that would increase bank risk more than decrease it, at least at this point.

By the way the 1927 McFadden Act banned interstate branch banking, in part to keep banks small, and economic historians usually consider that policy to have been a disaster which contributed to the severity of the Great Depression.

Here is a summary of where some of the debate on bank policy is at right now.


You might see large banks even if banks were perfect substitutes if there were economies of scale. And another upside is that small banks will have a harder time buying influence.

Also, why should this apply only to banks? One problem with size is that it buys the public perception of too large to fail and the political power to use that perception to get bailouts. i.e G.M.

By the way the 1927 McFadden Act banned interstate branch banking, in part to keep banks small, and economic historians usually consider that policy to have been a disaster which contributed to the severity of the Great Depression.

And to provide context, Canada did not have a bank law like the McFadden Act, and had no bank failures during the Great Depression. (Without something like FDIC then, either.)

Canada's banking has also fared better during this period. Clearly the answer is that we should emulate Canada's banking system-- there's only 100 years of evidence pointing to that.

There should be a price to pay for cheating.

Also, people would then hopefully think twice about concentrating their assets at a single bank. In fact, I myself store most of my (few) assets at a single huge bank, considering that it would certainly be bailed out by the government of Germany.

We want to the banks to be more self regulating -- to face downside risk from their actions. Limiting the size of banks could be a way of solving the government's time consistency problem: namely, "that ex post the bailout is always on its way so this is simply something we have to live with" (quoting Tyler,

maybe make cap requirements non-linear to cover systemic risks?

"namely that the way to prevent 'too big to fail; is to prevent 'too big.'"

Why do we keep ignoring the long-term problems caused by bailouts? When we bailout Citigroup when times get tough, banks will once again aggressively take on risk under the assumption that the gub'ment will be there to rescue them if things go wrong.

how about legislating a minimum level of loan defaults to keep people honest?

As long as you have lender of last resort, you have too big to fail.

While it would complicate things a bit, I think it is a tremendous idea. The banks that seem to have found themselves in the most trouble are the large, impersonal, coast-to-coast banks, where credit decisions are made in a vacuum and are a function of "crunching the numbers". The days of the community banker who knew the businesses and individual borrowers by name are long gone. These types of institutions are mush less susceptible to the kinds of speculative underwriting errors that were widespread in this situation.

There are paralels to the mortgage banker who once knew his customers and the business banker who would lend to his local middle market businesses. They both knew their customers well and held the risk on their own balance sheets. This made them more careful but also made lending decisions more personal and made defaulting much more difficult for the borrower. The CDO and CLO markets changed all of this. While there is much to be said for the rise of non-regulated credit creation, I think we have witnessed the dangers and getting back to more localized and regulated lending may be the right answer.

You have no idea how painful it is to write those words.

it seems part of the problem is that there won't be a timely distribution to creditors if a large institution fails. can't we just have these large insitutions run under a special charter that ensures that creditors are quickly paid at the risk that proper justice won't be done to creditors claims.

To get smaller banks, we probably need to separate backroom operations -- like brokerage firms do when they contract with Pershing for backroom stuff.

Note this allows us to separate customer service we'd get from an actual person from customer service we get via statements and computers.

In that way, when a bank gets too large, you could just split it off to shareholders.

Reminds me of a Vernor Vinge short story called "Conquest by Default" that featured a near-anarchist alien civilization whose only organizing principle was that there could be no organization of any kind that had more than so many members or clients. If they got too large they were forced to split into competing entities.

I don't know about legally limiting the size of a bank, but I do agree with the theoretical implications of making banks smaller.

That said, however, tax policies for mergers and acquisitions seem to be such that they encourage larger firms to takeover anyways.

I was just reading an article in a 1931 issue of Fortune; I forget the month. Back then, all banks were small banks. Interestingly, there were lots of bank failures in the 1920s. Some were based on fraud, either within the bank or by operators who specialized in selling risky assets to small town bankers who couldn't use Google to catch wise. The rate of failures tripled in the 1930s as the nation fell into depression. Back then it was unusual for a bank to have more than one branch, even within the same city, and the article made some good points in favor of encouraging larger banks which could hire professional investment managers and have larger reserves.

Our problem is less the size of the banks, and more the fact that the taxpayer is on the hook not just for savings deposits, but every investment the bank has made, and some of these were whoppers. If all the government had to do was insure deposits in savings accounts and money market accounts, we'd be in good shape. One possibility is to re-enact Glass-Steagal. If you want to be too big too fail, you have to play by certain rules. Otherwise, you can be as big as you want and fail as much as you want. (Interestingly, that old issue of Fortune has a discussion of this proposed legislation.)

A more sensible idea would be for the Federal Reserve to go retail. Back in 1931 banking was a complex, tedious business with passbooks, mechanical calculators, glassine envelopes of clipped coupons, clerks and more clerks. It took a lot of bookkeeping to run a bank. You could probably run a national scale bank on your iPod and host everyone's accounts on Facebook. The Federal Reserve should go retail. It could insure everyone's accounts for the first few million. It could lend money based on credit scores, and the government already has your tax returns. It could provide banking services to people too poor to afford them now. With interest rates basically at zero, it could even offer higher interest rates to encourage spending. It would have to charge lower service fees than any private bank; you could imagine the squeals of outrage if the government tried to charge the garbage fees a typical bank does nowadays.

Let's face it. When the dot com boom went bust, we didn't have the taxpayers bailing out or Cosmo. We don't need to bail out Bank of America either.

'They were lured by ideological notions derived from
Ayn Rand novels rather than economic theory.'

I'd like to see the empirical proof of this or should we
just assume that it is grounded in 'theory'?

In hindsight, we should not be surprised that un-
regulated profit-seeking individuals have taken risks from which they benefit
and others lose

This is just well, crap.

Finally, Yes we have seen seven decades of increasing regulation-these
are just 20 of the big signature laws that apply directly or indirectly
to Securities and Banking-not the reams of regulations issued by the
SEC, OCC, FDIC, Federal Reserve, Dept of Labor etc†¦
(I gathered this five minutes, wonder else I’d have thought of in a hour)
1. The Securities Act of 1933
2. The Securities Exchange Act of 1934
3. The Public Utility Holding Company Act of 1935
4. The Trust Indenture Act of 1939
5. The Investment Company Act of 1940
6. The Investment Advisers Act of 1940
7. The Securities Investor Protection Act of 1970
8. Fair Credit Reporting Act (FCRA) 1970
9. Currency and Foreign Transactions Reporting Act 1970
10. Employee Retirement Income Security Act (ERISA) 1974
11. Home Mortgage Disclosure Act (HMDA) of 1975
12. Community Reinvestment Act (CRA) 1977
13. Foreign Corrupt Practices Act of 1977
14. Depository Institutions Deregulation and Monetary Control Act 1980
(despite the name, it increased Federal Control over Banks)
15. Expedited Funds Availability Act (EFA or EFAA) 1987
16. Federal Deposit Insurance Corporation Improvement Act (FDICIA) 1991
17. Truth in Savings Act 1991
18. National Securities Markets Improvement Act 1996
19. Regulation FD 2000
20. The Sarbanes-Oxley Act 2002

The banks are gone. They serve one purpose, to match borrowers to lenders (depositors) via due diligence on loans. They can't even do this, as evidenced by the Big Bank FAIL. They tried to shirk their one duty by relying on the panacea of diversification. In other words, they stopped creating value in the tacit belief that they couldn't.

I predict they will be replaced by a web site.

Many banks are in trouble, is this not evidence that this is not a too big to fail case. If we had smaller banks would not be in a too many failures situation.

Now we have only one agency that control money supply, is this a problem?

Tyler:"I believe the plan would require very tight restrictions on off-balance sheet activity."

Off balance sheet activity should be eliminated. Period. It is impossible to evaluate the solvency of a company unless you can see the off balance sheet activity. Didn't we learn that with Enron?

Second, implement leverage limits of 10:1 or 12:1.

I am less interested in managing the sizes of banks then limiting the ability of a large mistake in valuation of an investment vehicle from spreading through every bank, creating the equivalent of a single financial institution when in crisis.

I'd like to explore creating separate spaces for financial institutions, with each space being allowed to hold different types of assets. There would be no restriction on access into these spaces, but if an institution were in one, it could not be in the other.

In this way, contagion could be limited, cordoned off, and allowed to fail, with the other financial institutions doing increased business as there would be no need to question how much contagion had infected them.

Devils in the details, of course. But for those who like the idea of competitive governments, I think it makes sense to acknowledge that 'finance' acts as a singular entity in crisis, and we would be better off setting up separate playpens for groups to compete, so that we have actual alternatives.

Well, yes, but the only reason the McFadden Act contributed to the Great Depression is because we didn't have FDIC insurance on individual deposits then. A small bank with only a single branch is inherently more likely to be affected by a 'local disaster' (say, a plant closing), but that hardly increases systemic risk in any way.

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