The Paulson/Yglesias Small Bank Plan
Hank Paulson speaking today:
We need to get to the place in this country where no institution is too big or too interconnected to fail. Because regulation alone — and I’m all for more effective, better regulation, more authorities — but regulation alone is never going to solve the problem. There’s no regulator that’s going to be so good that they’re able to deal with it and ferret out the problem. It takes a balance between the right regulatory system and authorities and market discipline.
This seems to me to be in the spirit of what I said last week:
[W]hat’s the deal with banks that are too big to fail?
If we can identify such banks, why not try to make a rule preventing banks from becoming that big? As a tradeoff, banks that rested in the small-enough-to-fail category could be allowed to operate with much, much laxer oversight and regulation since everyone would understand that if they fail they’re going to sink. Presumably, there are some efficiency gains associated with the economies of scale involved in big financial institutions. But there would also be efficiency gains associated with relaxing the regulations on financial institutions. And the only reasonable way to seriously relax those regulations would be to commit to a no-bailouts scenario. But to do that, we need to make sure the banks aren’t too big to fail. So why not focus the regulatory effort on that — on making sure that institutions don’t get so big that they need bailing out?
The difference is that Paulson is the Secretary of the Treasury and I’m just a blogger.
But Paulson’s actual policies seem to me to be pointing in the opposite direction. As we’re propping financial institutions up, we’re also encouraging them to consolidate. Beyond that, the tendency has been for the larger institutions to be the ones in the worst shape. By preventing them from failing, we’re preventing smaller but better-managed institutions from flourishing in their place. The logical endpoint of something like that would be for the entire financial sector to eventually be concentrated in the hands of four or five gigantic multi-purposes financial institutions all of which operate with implicit government guarantees and allegedly tight regulatory oversight that naturally becomes regulatory capture as soon as people stop paying attention.
A better path than the one we’re on would be to first stop spreading money around at random, and start using it to buy common stock, Sweden-style, effectively nationalizing the banks. Then we shutter institutions that are beyond repair and fix the rest. Then when we reprivatize banks, which should be done as quickly as possible, we break them up and sell them as smaller institutions. You then need regulators to, in the future, effectively cap the size of the banks so that no institution reaches a scale whereby we wouldn’t be comfortable allowing it to fail. Whatever efficiencies are lost by preventing really big banks, we can try to offset by giving them more latitude to conduct their business as they see fit.
40 Responses to “The Paulson/Yglesias Small Bank Plan”
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December 1st, 2008 at 4:32 pm
Banks are getting too big, but that is not the current problem.
This crisis is systemic and global, the entire financial markets are crumbling. If there were a lot of small banks in the US at the moment, many would be bankrupt and a giant bailout would still be necessary to save at least some.
But at least the Treasury wouldn’t be able to play favorite between a few giant corporations.
December 1st, 2008 at 4:37 pm
so you mean “banks, after a point, become too failure-prone to grow”?
December 1st, 2008 at 4:52 pm
If only we had some sort of law that prevented excessive industry consolidation.
December 1st, 2008 at 5:04 pm
A better path than the one we’re on would be to first stop spreading money around at random, and start…
…having any reasonably well-defined strategy, which would be better than none at all. At least from a bad strategy, we’d learn something from our failures.
December 1st, 2008 at 5:06 pm
Matt,
That larger banks lead to higher efficiencies is questionable.
http://www.nakedcapitalism.com/2008/12/meredith-whitney-sounds-like-nouriel.html
December 1st, 2008 at 5:11 pm
I have to say, I find the logic behind this confusing. As I understand it, the argument being made is:
1.) Banks/Financial institutions are always going to stay ahead of government regulations.
2.) Therefore any attempts to keep “too big to fail” banks from behaving irresponsibly are doomed to failure, meaning that any banks that are “too big to fail” ultimately will, in fact, fail.
3.) Banks that are “too big to fail” are therefore an unacceptable danger to our economy, and should be prevented.
4.) Let’s prevent them from coming into being…. through government regulations!
I don’t see any reason that regulators would be more able to prevent banks from growing too big to fail (corporations are designed to focus like a laser beam on growth) than to prevent mega-banks from behaving irresponsibly. So if you take 1.) as given (and it’s not implausible) then the proper conclusion appears to be that we’re just doomed to financial collapse every few generations. Which is a hypothesis that stands up pretty well to the empirical evidence of the last 200 years.
December 1st, 2008 at 5:39 pm
Heh. He said ‘market discipline’. Heh.
December 1st, 2008 at 5:41 pm
Over the weekend I raised Matt’s point that banks that are “too big to fail” might also be too big to exist with my father, a very conservative banker. To my great surprise, my father immediately agreed that this was exactly right.
“Either that or we need to regulate the shit out of them.” This coming from a man who tends to laud the market and condemn regulation of all kinds.
OhioBoy, I think one point in favor of preventing financial institutions from getting “too big to fail” is that adequately regulating them any other way is bound to be very complex and bound to be skated around by the institutions as time goes by. If we have a strong watchdog that simply watches for banks making too many acquisitions and being responsible for greater than some agreed-on percentage of the nations economy, then we can break up the banks. Breaking up large institutions is something the government has over a hundred years of experience doing.
December 1st, 2008 at 6:01 pm
Rob Mac: saying that banks can’t be “responsible for greater than some agreed-on percentage of the nations economy” sounds simple enough, but what does “responsible for” mean? It seems to me like the whole catalyst for this crisis was that banks turned out to be “responsible” for way more than anybody, including the banks themselves, thought they were. The government regulators obviously thought that Lehman Brothers wasn’t “too big to fail,” but it turns out they were wrong.
And more importantly, the reason that they were wrong (from my basically uninformed layman’s perspective), was that Lehman Brothers was NOT actually “too big to fail”, it was too INTERCONNECTED to fail, so it took a bunch of other institutions, each of which individually was small enough to fail, down with it. It seems to me that if, instead of 5 or so major investment banks, we’d had 50 or so, each of which was 1/10 the size, it wouldn’t have made any material difference to the crisis, because the nature of a financial crisis is that it hits all the players at the same time. I think the phrase “too big to fail” is a useful shorthand that, in some contexts, obscures more than it reveals.
December 1st, 2008 at 6:07 pm
The ‘keeping banks from being too big to fail’ was roughly in place until fairly recently, and was the result of regulatory policy changes, at the Federal level.
Once upon a time. most bank regulation occurred at the state level, and since state bank examiners didn’t want any outside interference from other state’s bank examiners (and the development of laws of incorporation during the 19th century contributed to this also, but that would be a long digression), this limited deposit taking to one state only, though in PA state law insisted on only one county, and maybe other states did that as well. Since there were no ‘national banks’ though there were national bank charters before 1980 there weren’t any ‘national banks’, no bank could really get all that big.
All the talk about the current problems coming from the gradual repeal of the Glass Steagal from 1980 to 2000 are generally barking up the wrong tree, the gradual allowance of interstate banking (where banks could take deposits and have branches in more than one state), which occurred concurrently, and led to bigger and bigger banks would seem to have mattered far more, if bigness is where the badness is coming from.
If the Feds just repealed the Bank Holding Company Act, they wouldn’t have to do much of anything else, if banks being too big were thought to be a problem.
The Depression still happened though, even when the banks were relatively small, I wouldn’t consider that a silver bullet.
December 1st, 2008 at 6:14 pm
Ohioboy says:
I thought the premise of capitalism is that businesses should focus like a laser beam on profits.
If corporations focus like a laser beam on growth, it’s hard to make a case for allowing them to be privately owned at all.
December 1st, 2008 at 6:25 pm
There’s actually a much simpler solution to this: Reverse the decades-long push by conservatives to hamstring antitrust law. Recognize that one goal of antitrust law should be to prevent the creation of entities that are “too big to fail.”
December 1st, 2008 at 7:03 pm
Others have brought this up, but: How exactly is an unregulated $40-trillion market in derivative securities any different if the players are a bunch of small banks rather than a few large ones?
It seems like it’s the large amount of “toxic waste” that’s out there that’s the problem—not its relative concentration. Please advise.
December 1st, 2008 at 7:10 pm
There’s no topic like finance to bring out ignorant morons who lack even the most basic knowledge, but nevertheless know exactly what we need to do to solve our problems.
As was mentioned here the last time this topic came up, the purpose of anti-trust law is to ensure competition and prevent companies from using monopoly power to reduce consumer welfare. It has nothing to do with “too big to fail.”
Yeah sure, massive monopolies suck and massive government bailouts suck. Just because they sound similar and they both suck doesn’t mean you use the same tools to get rid of them. No, it’s not “all connected.” In fact, steps you take to improve competition between banks may very well partly contribute to a banking crisis (competition means banks work harder for profits which means they have to get more creative). And it’s something in the nature of finance that the level of competition cannot be fully controlled by the government.
Say we chopped Citigroup into 1,000 pieces all “small enough to fail” and let them all fail. How would that be different from not bailing out Citigroup? Maybe “too big to fail” means “big enough to successfully lobby the government for bailout funds.”
This is not to say that bank mergers have been a great idea, or that banking has been intelligently run, or whatever. But just because something “sounds good” doesn’t mean it makes any sense.
December 1st, 2008 at 8:48 pm
What does it mean to let smaller, well-run banks “flourish”? Does that mean make lots of profits but not grow (i.e., not reinvest profits in the firm)? Does it mean they get to grow — but only up to a point, and then the government breaks them up into smaller entities? Who decides where that point is?
I’m not arguing one way or another; I’m just curious where you stand, Matt.
December 1st, 2008 at 9:21 pm
As far as I’m aware this idea isn’t nearly as innovative or original as you think. I gather that anti-trust laws decades ago prevented banks getting too big – but when a big financial crisis started in 1929 these feeble banks toppled like ninepins with consequences we all know about. Maybe this account is false or inapplicable, but it’s a historical example of which you seem to be taking no account at all.
December 1st, 2008 at 9:43 pm
Economy of scale: The size at which corporations become too big to fail, and therefore gain access to the Wall Street – Washington D.C. markets for lobbying, influence peddling and political corruption.
December 1st, 2008 at 11:38 pm
So who, exactly would a big global company like McDonalds, Coca Cola or P&G go to to meet their diverse and large, commercial banking needs. Any bank big enough to serve the biggest American companies will end up being too big to fail. What if, like GE, they have a bank in house and that bank gets to big to fail?
December 2nd, 2008 at 1:52 am
NEVER say you’re “just a blogger”
Signed,
A blogger.
December 2nd, 2008 at 9:50 am
Big banks need lots of bulkheads.
December 2nd, 2008 at 9:55 am
“Too Large To Fail” banks could be required to have a much higher percentage of reserves. The definition of “Too Large To Fail” could be tweaked, but it should always include the three largest banks. That would put the willy on insane bank growth.
December 8th, 2008 at 2:30 pm
By Steve Slater and Paul Hoskins LONDON, Nov 18 (Reuters) – Banks around the world unveiled a fresh round of profit falls, job cuts and austerity measures on Tuesday but share prices fell anew as investors remained focused on whether the
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