Too Big to Exist
Elliot Spitzer, now writing columns for Slate, gets on the too big to be allowed to exist bandwagon:
Imagine if instead of merging more and more banks together, we had broken them apart and forced them to compete in a genuine manner. Or, alternatively, imagine if we had never placed ourselves in a position in which so many institutions were too big to fail. The bailouts might have been unnecessary.
I wouldn’t say “might.” The merits of the idea is that by definition firms would not be allowed to reach a size such that bailing them out in case of failure was necessary. You would lose economies of scale that are presumably efficiency enhancing (although I’d like someone to explain to me exactly what this efficiency has gotten us) but you could make this up on the back end by regulating the firms less stringently, since it’s the potential need for bailing out that drives the need for regulations.
Now perhaps there’s no feasible way to design and implement such a rule. Certainly I couldn’t design and implement one. But I wouldn’t mind seeing someone who has the right kind of background — someone like Elliot Spitzer, perhaps — take a shot at saying in more detail what this would look like and how it could be implemented.
43 Responses to “Too Big to Exist”
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December 4th, 2008 at 2:14 pm
It seems that even if we had a bunch of small banks rather than a few huge ones there might be circumstances in which most of the small banks would be in danger of failing at the same time, in which case a bailout might be necessary.
December 4th, 2008 at 2:16 pm
Wait, did Matt just look at a post after writing it and fix an error?
December 4th, 2008 at 2:18 pm
I think this might be too simplified. AFAICT, the problem isn’t really size but interconnectedness. One assumes that smaller banks would just be more connected and just as prone to fail b/c of the failures of counterparties. If we choose a big bank–say Citi–and label Floor 2 as “Firm 1″ and Floor 8 as “Firm 2,” has anything important changed?
December 4th, 2008 at 2:24 pm
Argh. What KCinDC and SomeCallMeTim said. As far as I can tell, it’s the $10 trillion in toxic-waste securities that are the problem—not the size of the entities holding it.
All this talk of “bigness” seems, to me, to be the worst kind of meaningless political grandstanding.
December 4th, 2008 at 2:25 pm
You still have to regulate and limit the leverage. If a small
bank has $C of capital, but chooses to operate with 50x
leverage, then it’s failure will cause as much counterparty
damage as the failure of a bank with $5C capital at 10x leverage
(and the smaller more-highly-leveraged bank is also much more
likely to fail).
So I don’t think “size” is the problem: the problem is high
levels of leverage, and especially high levels of leverage
combined with insanely complex and obscure financial instruments
which fool all of the regulators, rating agencies, and the banks’
own internal risk management systems.
More transparency; less leverage. Size should in theory be
a good thing, since a large bank can be more widely diversified over a range of activities and regions to somewhat
reduce risk (though as Krugman said, in a crisis all correlations go to 1, so diversification isn’t as good as it
looks on paper).
December 4th, 2008 at 2:28 pm
How would it work? It would work something like the Sherman and Clayton acts worked in breaking up the monopolies. But then again I wouldn’t expect someone like Matthew who has a degree in bull (see philosophy) to understand anything about history or how it can relate to present times.
December 4th, 2008 at 2:35 pm
Again, we’ve had empiric proof just in the last couple of months that we don’t know who is and isn’t too big to fail. We thought that Lehman Brothers wasn’t, but most people now seem to think that was incorrect. Is Detroit too big to fail? Who knows?
And is there any evidence that a lack of competition was the problem here? These firms may have been big, but they weren’t monopolies, and they were in fact competing. They were competing with each other for who could leverage up the most to buy up the most phony paper with manufactured AAA ratings, in order to book phantom profits and rake off massive bonuses and dividends. I can’t see anything that would have been different if there had been 50 smaller banks doing that instead of 5.
If what we were dealing with here was a single institution, say, AIG, that had made some clearly bad moves and forced us to bail them out to save a bunch of other institutions that had behaved basically OK, then I could see this being a reasonable response. But the size of any single institution is irrelevant when they all fail at once. And the reason they all failed at once is because they found regulatory loopholes that allowed them to evade capital requirements, and because the credit ratings agencies all have conflicts of interest built into their business model.
No matter how many financial institutions there are, if one of them finds a way to run a Ponzi scheme and rake in profits, the others will all follow suit, and when it collapses, they’ll all collapse. The only thing we can do is be vigilant in our regulations to try to keep these schemes from getting run in the first place. Is that possible? Maybe not, as I’ve said before, nothing in history leads to the conclusion that financial crashes are avoidable in the long term. But thinking that we can relax regulations if we just have a bunch of smaller institutions seems insane to me.
December 4th, 2008 at 2:36 pm
No, this argument is for AIG, the investment banks, and any other non-bank financial institution that was considered “too big too fail”.
Sound policy would still step in if a large share of the nation’s depository institutions were going to fail without help … whether that share is two or three banks or two or three hundred banks. More than 90% of our money supply is credits in banking accounts: depository institutions are not merely too big to be permitted to fail, but also too central to the income-expenditure GDP cycle to be allowed to fail.
Of course, sound policy would also step in and restrict depository institutions to banking practices and balance sheets that make them unlikely to fail … a major regulatory advance of the New Deal was establishing a very robust commercial banking system, and a lot of time and effort since the 1950’s has gone into getting back to a situation where we can have a good old-fashioned 18th century Bank Panic once more.
December 4th, 2008 at 2:36 pm
Well–small bank DEPOSITORS get “bailed out”–that’s the purpose of the FDIC. The BANK may not survive, but the depositors get their money, and the debtors have to pay their loans.
December 4th, 2008 at 2:42 pm
There’s also the inconvenience that big businesses kinda need big banks. They need someone who can give them a $4 billion revolving loan, who has offices in lots of countries, can handle a client with operations in different currency and interest rate environments, etc.
I suppose those services could be split up or handled through large syndicates to some extent, but transaction costs and bureaucratic complications would increase dramatically and it’s not clear (with that degree of interconnectedness) that you’d avoid the risk of systemic failure.
December 4th, 2008 at 2:43 pm
Did someone really just say that Eliot Spitzer is the person you want doing something? Wow, I thought that would take longer.
December 4th, 2008 at 2:58 pm
It does seem to my financial-illiterate brain that size can’t be the only issue that could ever exist. Surely, even if not letting banks get too big to fail would have prevented this particular scenario, isn’t it conceivable that in the future we could have a situation where some other fundamental banking problems manifest and instead we’d hand out a bunch of mini-bail-outs?
With that said, I don’t know, there might be some merit to this idea. I wonder if Bear, Lehmen, Merrill, etc. had been broken up or never became so big. Would the substituent fractions all have faced the same exact problems? Surely not all would have such toxic leverage on their balance sheets. It seems to me that these big banks let one portion of their portfolios infect the rest of thier value (or something… I remember stock values taking quick tumbles but that doesn’t mean an entire company is 100%, across-the-board worthless, does it?) In other words, I have to assume there were positive assets here that got tangled up with the bad; thus, wouldn’t there have been a bunch of good, balanced banks along with who knows how many crappy, over-leveraged ones? Or would every small bank out there have been nothing more than esentially a cross-section of Bear Sterns?
Any way, someone smarter than I might make better sense of what I’m trying to say here. Sorry.
December 4th, 2008 at 3:01 pm
Well–small bank DEPOSITORS get “bailed out”–that’s the purpose of the FDIC.
And generally when a small bank is failing, the regulators look for a large bank to take it over, rather than the FDIC simply paying for the deposits. They like large banks.
December 4th, 2008 at 3:52 pm
What’s the point of competing if success will only result in the government breaking you up again?
December 4th, 2008 at 4:04 pm
I think Spitzer’s hit the nail on the head. Just like AT&T was too big, and so the Federal Government broke it apart (anybody here old enough to remember that?) and the EU argued Microsoft was too big and had a monopoly.
But we also still need to regulate financial institutions (banks and insurance, both) more; make sure that they have the capital to cover their risk. That isn’t rocket science, and it never was. It was always a ponzi scheme. Remember, AIG’s problems stemmed from insuring risk produced by both natural disaster and financial collapse at the same time. They couldn’t afford hurricane loss and pension collapse at once.
There are a few other firms I’d say are too big, too; starting with WalMart. Whenever a company gets that big, as the Big Three currently demonstrate, it’s financial health becomes too intertwined with the national financial health; perhaps the international health. Spitzer’s right; too big means we can’t afford to let market forces play out, can’t afford the costs of a failure.
Enron, AIG, Lehman’s, GM, they all should be teaching us a lesson — size matters; the cost of too much size, either financial size or too many jobs — and the burden that failure of too big a company places on the rest of the nation or the rest of the world, should be considered. Because when a company is too big, its not like a company failing, it’s like a government failing.
December 4th, 2008 at 4:30 pm
I wouldn’t mind seeing someone who has the right kind of background — someone like Elliot Spitzer, perhaps — take a shot at saying in more detail what this would look like
hahah. — how bout this? http://profile.myspace.com/index.cfm?fuseaction=user.viewprofile&friendID=69041220
December 4th, 2008 at 5:22 pm
Deja vu. Matt didn’t even bother to respond to any of the comments he received that last time he floated this idea.
December 4th, 2008 at 5:26 pm
How exactly do you get the benefits of an economy of scale in the financial sector? There is no overhead, everything is on paper. How is a large financial firm more efficient than a medium sized one? It seems to me that these firms got so large not because they were more efficient that way, but because their profits increased linearly with the size of their assets. There was no intrinsic benefit to being large, it just meant the firm had more money to invest.
December 4th, 2008 at 5:49 pm
Not to contradict everyone, but there’s plenty of reason to believe that a banking industry made up entirely of small and medium sized banks would not have ended up in the same mess to begin with. A lot of the risky investments were pushed by big investment banks. I don’t think small banks would have invented them themselves.
That said, I think we really would just be seeing things moved down to a different scale. Instead of having big national banks and manufacturers that were too big to fail, we would have regional banks and manufacturers that were too big to fail. One of the big problems that has arisen out of bank mergers over the past thirty years is that banks no longer feel the need to invest in their own community. It used to be that banks invested a lot of their money into their local communities and businesses; now, it is all invested wherever you can make the biggest buck. But, the downside of investing in your community was that if the big employer in your area was going to fail, the bank had to prop them up. So, they were literally “too big to fail,” even if the scale was local instead of national. So maybe we really aren’t any better or worse off…
December 4th, 2008 at 6:07 pm
In addition to the argument that largeness of banks allows for diversification of risk, there’s also the fact that bigger banks can afford to make bigger loans. So even if there aren’t always economies of scale in risk diversification, big banks can create economies of scale for businesses that need big loans. Rather than coordinating and taking out 10 $1 Billion loans from 10 banks, a company could take out 1 $10 Billion loan from a single bank and not have to negotiate 10 times.
December 4th, 2008 at 6:22 pm
It’s probably not even necessary to force banks to be small, only to ensure that the bigger a bank gets, the higher their capital requirements are and the lower their allowable level of leverage.
Because big, multi-national companies are always going to be interested in doing business with big banks, there’s no worry about all the money flocking to small, risky banks.
December 4th, 2008 at 6:54 pm
I would chime in with the point I always make when Matt brings this up, but it’s already been done 15 times in this thread and approximately 50 times in the last two threads, so I won’t.
December 4th, 2008 at 8:46 pm
Perhaps this can be attacked from the other end: by making it easy (or easier) for banks to open. I have no idea what the barriers to entry in this field are, nor can I say that this would make much of a difference. But intuitively, it makes sense to think that we’d be served well by a greater number of small banks (and relatively small banks) just as well as much as we would by massively large financial institutions.
December 4th, 2008 at 9:52 pm
Of course there’s a way to implement Spitzer’s approach. All that’s needed is to start enforcing the anti-trust laws that the Reagan decided were outmoded.
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