Should we break up the large banks?

In my column today, I say no.  Here is part of my argument:

…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.

The rest of the piece considers non-limited liability as an alternative for banking reform, and I thank Scott Sumner for drawing my attention to a recent piece by Eugene White (pdf) on this topic.   Stephen Williamson comments, see also his references.  I’ll respond to Arnold Kling’s remarks in a separate post, soon enough probably tomorrow.


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