Inside Financial Services

Regulators, Quit Trying To Downsize The Big Banks

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The Fed’s proposed capital plans for the big banks are out, and look to be as counterproductive as some of us feared. From the Wall Street Journal:

 

The proposal, which will be phased in starting in 2016 and take full effect in 2019, is aimed squarely at pushing big banks to shrink, an outcome regulators were explicit in saying they hope to encourage to reduce the likelihood a firm’s failure could require bailouts or damage the broader economy.

 

To meet the new capital charge, banks can either fund themselves with significantly more equity—which tends to be more expensive than deposits or borrowed money—than their smaller peers. Or they can get smaller and make other changes that would reduce the size of their extra capital levy. {Emph. added.]

 

So federal banking regulators, in an effort to do something about “too-big-to-fail,” are now openly pursuing policies that could force the country’s biggest banks to make themselves smaller. This is a terrible idea. Believe it or not, large banks serve an important economic function. There’s a good reason they’ve come to exist in the financial marketplace: certain large banking customers have complex financial needs that are best met by large, broadly diversified financial services providers. American Airlines isn’t going hedge its energy risk using Acme Community Bank as a counterparty. Nor is IBM likely to turn to Acme for multi-currency global lines of credit. In banking, size matters. Sorry.

 

So if the regulators do succeed in forcing banks to downsize themselves, one direct result will be that many of the banks’ big customers will simply take their business to large foreign banks who’ll still have the heft to meet their needs. The result will be a net economic loss to the economy. How’s that a good idea?

 

What’s more, it’s not clear that downsizing the big banks will, in and of itself, serve to strengthen the financial system. If anything, the opposite is more likely to be true. A number of businesses the banks jettison will likely migrate to the (unregulated!) shadow banking system. We’ve already seen the happen with activities like mortgage servicing and securities trading. Banks are even being pressed to pare back their deposit-taking—a core banking business if there ever was one. Thus billions in large corporate deposits may be headed to alternatives such as unregulated, uninsured money market funds. Runs by jittery holders would become more likely, not less so. At the same time, the downsized banks would be left with less-diversified books of business and so would be more vulnerable when the next financial crisis hits.

 

The myth persists that it was the megabanks’ sheer size that brought on the financial panic and subsequent bank bailout. Wrong. It was bad lending that caused the problem. In particular, too many banks—big and small—lent too much mortgage money to too many subprime borrowers. When those loans went sour, virtually everyone was loaded down with the same toxic paper, so that no one trusted the value of the assets on each others’ books, and funding froze. If a lending debacle of the same scale had occurred in a financial system that consisted of banks that were of acceptable size to regulators, the ensuing panic would have occurred just as it did—including the taxpayer bailout. As it happens, most of the big banks came through the crisis relatively well, since they had healthy non-subprime business (many of which they soon may be forced to exit) that could offset their lending losses. Those banks didn’t want or need the bailout money the government forced on them.

 

Too big to fail is a problem that needs to be fixed. The way to do that, in my view, is to come up with a privately funded liquidity provider that can keep the system afloat when the next crisis hits. But size is beside the point. (If you doubt it, the Canadian banking market is dominated by four institutions, but for some reason there’s never a drumbeat there to break those institutions up.) Regulators’ fetish with downsizing is counterproductive, and won’t fix the problem anyway.

 

What do you think? Let me know!

5 Responses to “Regulators, Quit Trying To Downsize The Big Banks”

  1. Oy

    Bull twinkies. The point is that if one of these behemoths does hit the wall, it takes down the system. Regardless of what patch is applied to the current set up, somebody is bound to press the boundaries too far. It happens every time. So it would best if the damage were contained to a size that can be dealt with and one that minimizes the risk to taxpayers.

    • BLS

      Please walk me through how one of the behemoths ‘takes down the system’. Everyone says that but I don’t understand how that works in practice. It’s like it’s some magical chain reaction that catches onto every other institution. How do banks catch a cold from another bank? Please explain.

      On top of your first comment, taxpayers shouldn’t be on the hook anyway. So maybe that’s our first and more important problem.

  2. Ben Dover

    The costs of doing business with a smaller bank will be larger, I think it’s hard to rationally argue your way out of that. The way I read this is that the big financial supermarket complexes have basically proven that they are impossible to manage and maintain good risk oversight. Why not just disallow the disentanglement of underwriting, lending, and holding of the securitized mortgage pools? They can still issue some, but not all of the mortgage pools. My point being if you have to eat your own cooking I would think the volume and quality will be self regulated as the bank now has it’s own capital at risk. Same with lending and investment functions. Why should you get FDIC protection on deposits if you want to do trading activities? The trading and capital markets banks need to risk their own capital as they did when they were partnerships. In my mind this would solve all this over regulation and regulator capture problems.

    • Ossama

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  3. Milkweed

    Correct me if I’m wrong but didn’t ALL of the TBTF banks pay back every cent of the so called “bailout” with interest in less than a year? I believe we lost money on the UAW bailout though. However the UAW bailout is hailed as a triumph of government intervention, and the bridge loan to the TBTF banks is an abomination never to be repeated again. I must be living in bizzaro world where making money on an investment is bad and losing money is good.

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