NEWS FLASH: BIG-BANK BREAKUP WILL MAKE FINANCIAL SYSTEM MORE COMPLEX, NOT LESS SO

At Naked Capitalism, Yves Smith takes some potshots at Peter Wallison and his recent takedown of the break-up-the-big-banks zealots:

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At Naked Capitalism, Yves Smith takes some potshots at Peter Wallison and his recent takedown of the break-up-the-big-banks zealots:

While it would clearly be desirable to reduce the size and degree of integration of the “too big to fail” banks, the first order of business is to reduce interconnectedness. Even if the officialdom finally got the willpower to split up the behemoth firms, the authorities clearly regard the capital markets as too important to allow to fail. Although bank lending is important, in the US, more credit is ultimately provided through securities markets than on balance sheet bank lending. These markets are over the counter, meaning the big dealer banks buy and sell from end investors. The dealer banks are tightly interconnected via counterparty exposures (particularly in derivatives markets). As we saw with Lehman, if one goes down, it has serious ramifications for its peers. And because the dealers tend to pursue similar strategies, when one looks wobbly, providers of short-term funding for the entire industry start looking for the exits. So reining in over-the-counter derivatives, particularly credit default swaps, needs to be a top priority.

Am confused. If the “first order of business is to reduce interconnectedness,” Smith should be plumping for a simpler network that has fewer interconnections and is easier to oversee, right? But a breakup of the big banks would produce the opposite: a network consisting of many more nodes-that is, financial institutions-that would be exponentially more complex than the current one is. How is that an improvement? Nor would such a network, had it been in place in 2008, have prevented the calamity that happened. The problem then, recall, was that too many institutions owned too much of the same thing: rotting subprime mortgage debt. It wouldn’t have mattered whether that bad debt sat in many, many little buckets or a smaller number of larger ones. The losses were going to happen, no matter what. Institutions still would have run into funding problems. Even then, there is one advantage to size. As Dick Kovacevich points out, it provides an opportunity to diversify away from stuff that goes bad. That’s not a small thing. It’s one reason Wells Fargo was able to stay out of trouble. . . . Smith is right about needing to rein in CDS, however. . . . P.S. Am not sure why Smith feels compelled to take a few shots at Wallison’s integrity along the way (his argument is purportedly “strained at best, completely dishonest at worst”). When did rational argument and the assumption of good faith go out of style? I like to be snarky, too, but will sometimes give it a rest. . . .