In the new Minneapolis Fed paper, “Too Correlated to Fail,” V.V. Chari and Christopher Phelan argue attacking “Too Big To Fail” and moral hazard by limiting bank size won’t by itself end the moral hazard problem caused by financial institution anticipating government bailouts:
In this paper, we argue that the anticipation of bailouts creates incentives for banks to herd in the sense of making similar investments. This herding behavior makes bailouts more likely and potential crises more severe. Analyses of bailouts and moral hazard problems that focus exclusively on bank size are therefore misguided in our view, and the policy conclusion that limits on bank size can effectively solve moral hazard problems is unwarranted.
It is an intuitive conclusion. What good is many smaller banks and fewer big banks if herding results in the risk profile of the broader financial system remaining unchanged? Banks of whatever size will be encouraged to take the sort of macroeconomic risks (mortgages rather than small business) that would result in bailout if they went bad. Indeed, Chari and Phelan highlight how the securitization process “ensures that all banks end up holding very similar portfolios and thus have highly correlated risk.”
All this very much syncs with what Ashwin Parameswaran has written on how the “Greenspan Put” and its emphasis on supporting asset prices and thus the banking system — think Long-Term Capital Management — negatively affected the financial system by encouraging herding and the real economy by encouraging financialization:
If you protect a system from the effects of any particular risk, actors within the system will take on more of the protected risk assuming rationally that the system manager (in this case the Fed) will protect them. The Greenspan Put regime drove down the risk of being exposed to broad macroeconomic market risk. Market participants rationally took on more macroeconomic asset-price risk and substituted for the risk they had been relieved of by the Fed with more leverage. …
And this is exactly what the financial sector proceeded to do. Far from being a neutral channel of monetary policy from the Fed to the real economy, the deregulated yet too-big-to-fail financial sector that was also protected from new entrants realigned itself to take on macroeconomic risk by lending to housing and large established firms. The attractiveness of this strategy meant that banks shunned lending exposed to non-macroeconomic idiosyncratic risks such as lending to small businesses or new firms. … The doctrine also encouraged firms in the real economy to become as bank-like as possible. No firm took advantage of the new regime like General Electric(GE) did. GE under Jack Welch transformed itself into an industrial firm whose profits came largely due to its financial arm, GE Capital which lent to its industrial customers (amongst others). So successful was this transformation that by the time the 2008 crisis hit, GE had also become too-big-to-fail thanks to GE Capital and was found to be eligible for a bailout.
In “Room to Grow,” I mention a couple of policy approaches including forcing banks to hold vastly more capital and increase financial industry startups.