Economics, Free Enterprise

Liberals and conservatives are both right about big banks

Image Credit: Shutterstock

Image Credit: Shutterstock

Last weekend, the New York Times and the Wall Street Journal ran dueling op-eds on the state of financial regulation. Each piece argued about what you’d expect.

In the Times, Stanford’s Anat Admati proclaimed “We’re All Still Hostages to the Big Banks”:

Nearly five years after the bankruptcy of Lehman Brothers touched off a global financial crisis, we are no safer. Huge, complex and opaque banks continue to take enormous risks that endanger the economy. From Washington to Berlin, banking lobbyists have blocked essential reforms at every turn. Their efforts at obfuscation and influence-buying are no surprise. What’s shameful is how easily our leaders have caved in… (emphasis added)

Admati’s solution? Impose stricter rules on fat cat financiers.

George Melloan’s WSJ piece argued the opposite. Entitled “Bankers Haven’t Gone Rogue — Regulators Have,” the article blasts bureaucrats for “wheeling and dealing, making rules, twisting arms, plotting civil actions, and levying fines”:

Regulatory mania is encouraged by the Obama administration, which struck political gold in 2012 by blaming the nation’s economic ills on the rich … The legislative and regulatory assault has done serious damage (emphasis added).

An elite academic criticizes capitalists; a conservative condemns overregulation. Seems like standard fare. But when we look beyond the tired, old narrative of right-wing business backers versus left-wing government cheerleaders, a surprising truth comes into focus:

Both critiques are on point.

Big banks do have it too easy. Per the chart below, America today is just as reliant on a few colossal institutions as before the meltdown. This is great news for those deemed too big to fail: Bloomberg View estimates that implicit guarantees boost megabank profits by more than $80 billion. Less lucky are the smaller firms that receive no such subsidy — not to mention the taxpayers.

But it’s also true that bureaucrats clumsily chaperoning banks through the minutiae of their operations won’t solve anything. It’s taking regulators an eternity just to write Dodd-Frank’s rules, injecting damaging uncertainty into markets. If and when they finish, compliance costs will devour yet more productive resources. Huge institutions can easily afford enough lobbyists and lawyers to navigate these rough waters. Smaller community banks? Not so much.

Both liberals and conservatives are right to criticize this worst-of-both-worlds status quo. Fortunately, AEI’s own Jim Pethokoukis and others have mapped a way out: Government should significantly increase banks’ equity requirements, then step back and let markets adjust. It’s simpler, fairer, and more pro-market than Dodd-Frank’s messy micromanagement — and it would strike directly at the heart of “too big to fail.”

These proposals cut across ideological lines to address both op-eds’ complaints. When it comes to taming the megabanks, left and right should unite.

6 thoughts on “Liberals and conservatives are both right about big banks

  1. Notice which commenter used facts and which used rant. Melloan martialed evidence and information. Not much there on the Admati side.

    The one chart that appears in this blog post shows that over the past 5 years large bank market share has been more or less constant. Take the data back about 25 years and they show that the banking share of the U.S. financial markets has actually been on a slow and steady decline, from 46% of the financial markets in 1990 to about 35% today. The non-bank share of financial markets has grown to 65%, or almost two-thirds of the market.

    Where has that erosion of bank market share taken place? Mostly in community banks. The larger banks look like they hold more of the banking assets because they have managed to hold their own in terms of market share, while community banks have steadily lost market share to their non-bank competitors.

    Admati’s plan is to address that by making sure that the larger banks shrink, too. Her mantra is that there is little difference between debt and equity when it comes to funding a bank’s assets. There are few takers for that purely academic view in the markets themselves. Increased capital requirements offer two choices to bank managers (keeping in mind that bank capital is measured as a ratio of capital to assets): either take on more capital for the same amount of assets and thereby dilute the ownership interests of existing shareholders, or shrink the amount of assets. Either way means continued reduction in market share for the banking industry and growth of the non-banking industry.

    And, by the way, the 2007-2009 recession began among the non-banks (Bear, Lehman, Fannie, Freddie, AIG).

  2. How nice of the head of the ABA to wade into the comments and attempt to disrupt the growing consensus on how to deal with a poorly-designed US financial system. First he replaces Admati’s argument (that the differences between equity and debt funding are such that we should prefer banks to fund with much higher equity than the status quo) with a lame straw man argument (“Her mantra is that there is little difference between debt and equity when it comes to funding a bank’s assets.”). He then makes a strange non-sequitur about how large banks make up the same size of the financial system as they did 25 years ago, which adds precisely nothing to the discussion. . Finally he points out the US financial crisis began among non-banks without noting that it then spread to the bank with 12% of domestic deposits, Bank of America, which along with Citi required a government bailout to survive.

    With more equity funding Wayne Abernathy’s bosses will make less money because of the reduced RoE for US megabanks. When you understand his motivation you would hope he could come up with better arguments.

    • Thanks for the promotion, whoever you are. Gladly, I am not the head of the ABA, but I am proud to work for the banking industry and the trade association that represents it. I notice that you do not challenge any of the facts that I present, that the banking industry is, in fact, contracting, in real and relative terms. The latest FDIC data, released just yesterday, show the second quarter in a row in which bank assets declined overall. The FDIC also notes that the number of banks dropped below 7,000 (the first time since about 1891), and they have not had a de novo bank since 2010. That means erosion of the number of community banks, which is a key point that I mention. And thanks for the point about BofA. BofA got into financial trouble when it came to the rescue (with a lot of regulatory nudging) of the failing securities firm Merrill Lynch, proving my point that the financial crisis began with the nonbanks before spreading to the banking industry.

      • Ha, of course, hopefully I didn’t upset Mr. Keating.

        You’re right, the banking industry as a whole is contracting, but neither Quinn nor Admati nor Melloan claim otherwise. The argument here is whether banks should operate with significantly more equity funding. Saying non-banks were the epicentre of the crisis does not refute this argument, it just reinforces that with US’s high level of financial disintermediation there needs to be work done to level the playing field between banks and non-banks.

        I am unclear how the erosion of community banks plays into this. If the largest US banks were to lose the implied government backstop their funding advantage over smaller banks would decrease (all with a big “theoretically” attached). Just as likely is the possibility that technology and economies of scale are pushing these tiny banks out of business. If I had access to better data I would be curious to investigate where the business is migrating to.

        • Shrinking the big banks by requiring that they hold excess capital solves no problem but will exacerbate problems, not the least of which is reducing the growth potential of the economy overall by reducing the efficiency of capital. As the most recent FDIC data show, all this mania about increasing already high levels of bank capital comes while the banking industry continues to contract. The point about the community banks is that while larger banks have more or less been treading water in competition with non-banks, community banks have been steadily losing ground in their competition with non-banks. Shrinking large banks and making them compete more with community banks will do nothing to help community banks.

  3. As a middleclass layman who was severely affected by the financial crisis (e.g. selling a home at a loss and losing much of my 401K savings), I come at this from a different angle. I don’t know whose figures are correct are that it really matters. I do know this; if the WSJ, Fortune, and other financial publications are right–that the biggest banks are making more money than ever, are still engaging in the use of derivatives on a massive scale; that they are still being allowed to slowy unwind their toxic assets by using shadow banking accounting rules; that Freddie Mac and Fannie Mae are bigger that ever–despite Congress saying they would dissolve them; and that as far as contraction of banks, there are more banks in every town I travel in than in any time during my 55 years of existence.
    When you allow institutions to gamble with peoples money and suffer almost no serious consequences, then you do not have a viable free market. What you have is a collaboration between oligarchies and the government. Adam Smith was for government regulation of banks and believed that they would collude with the government if given a chance to. He also believed that government should strongly regulate them. But both parties are beholden to the monied special interest groups. Until we outlaw groups or corporations from giving we will never have a Congress who is remotely interested in doing what is best for the Public Good. Smith also said, that massive profits should only exist for the innovators, and that these would subside as competition grew. Can anyone who claims to be a fiscal conservative, actually claim that the massive profits by the banks are justified year after year? A true free market would have long ago made these huge profits obsolete through competition. That they are not obsolete, should serve to instruct anyone who has read Smith, that something is foul.

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