3 approaches to fixing the banks and ending ‘Too Big To Fail’

I wanted to highlight a great guest post on ending Too Big To Fail by my pal Bob Stein, senior economist at First Trust Advisors and a former Treasury official. After dismissing ideas that are extremely unlikely to happen, such as ending deposit insurance or politicians actually restraining themselves from bailing out troubled mega-institutions, Stein runs through the realistic alternatives:

1. More regulation.

In theory, one way is Dodd-Frank, the route favored by the Obama Administration and congressional Democrats: increase regulation, give regulators more discretion, and hope they do their jobs better than any set of regulators ever has. Essentially, this approach gives more power to the same kinds of people who missed the shenanigans of Bernie Madoff, MF Global, Stanford Financial, and Peregrine Financial. And that’s just in the past few years. Faith over experience.

 2. Bust ‘em up. 

Another route is to break up the big banks. As Alan Greenspan has said, “If they’re too big to fail, they’re too big.” The problem with this approach is that it eliminates the efficiencies provided by large banks and assumes there is no possible beneficial tradeoff for bank size above a certain level.

3. Way more capital.

A third option would be gradually, but substantially, raising capital requirements for banks considered TBTF. Not the small increase already scheduled under Dodd-Frank. Instead, lift capital requirements to at least 25% over the next twenty years and apply it to all assets, including government debt. (Yes, that means you, Uncle Sam.)

Institutions that don’t want to hold more capital wouldn’t have to; they’d simply have to stay small enough to fail. And in the meantime, we could dispense with the Dodd-Frank rulebook that tries to substitute the judgment of government regulators for what these firms really need, which is more equity to back up risk-taking.

Stein makes a lot of sense. I think a lot more highly of option #2 than he does, especially since I am not sure what those much ballyhooed efficiencies are, and I think there are political economy reasons for not having a lot concentrated economic power with a few players all telling Washington to do the same thing. I also think the Stein plan just takes too darn long. But I don’t know of any reason why #2 and #3 couldn’t be combined in some fashion. I have heard and written about #2, and look forward to exploring and hearing more about #3.


2 thoughts on “3 approaches to fixing the banks and ending ‘Too Big To Fail’

  1. I, too, wonder about these supposed benefits of scale. In many cases, they have simply meant that it becomes harder and harder for senior management to understand, let alone manage such a giant organization. Among other things, it is almost impossible to prevent the creation of semi-autonomous fiefdoms from the various silos which tend to proliferate in a very large, highly diversified company. The advantage to issuers, that a single bank can buy a whole deal, means that all the risk is being borne by a single bank, or two or three at most, which is bad for the financial system, and none of the risk by the issuer, which is inherently illogical: given their much higher leverage, banks are inherently riskier, in the sense that their downside, if something goes very wrong, is much greater, than for most non-financial entities. Broad syndication was probably better for everyone. Similarly, having the capital to double down and double down again on a bet gone wrong is probably in no one’s interest except perhaps a trader who might recoup his losses, and if not, risks nothing more than having to find a new job.

  2. The benefits of scale are overwhelmed by (a) competition, i.e., the break up of ma bell; and (b) by eliminating the “big banks” and making a bunch of small ones, it closes the revolving door between the banks, treasury, and the fed, where the big banks write rules that are advantageous to them. IF there are a bunch of small banks, they can try, but with the number of small banks available, most small banks will be able to adapt quickly to new rules.

    Break ‘em up!!!

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