Breaking Up the Banks is Hard to Do

The
"too-big-to-fail" banks will be left in place, even bigger and less
accountable than before. There will be nothing done to separate
commercial and investment banking, so giants like Goldman Sachs
will be free to speculate with money guaranteed by the Federal Deposit
Insurance Corporation. The main difference is that the Federal Reserve
Board will be granted even more power
than it has now. And, we will tell the Fed to be smarter in the future,
so that it doesn't make the same stupid mistakes that gave us the
current crisis.

While we all want a smarter Fed, it is not clear
that the bill before Congress will get us one, even though it will
definitely give us a more powerful Fed. The new Fed will be able to
decide which financial firms need to be put through a bankruptcy-like
resolution process, paid for with a virtually unlimited amount of
taxpayer dollars.

While the bill proposes that the cost of cleaning up after a big bank failure is supposed to be paid by other big banks, in fact the mechanism laid out in the bill virtually guarantees the opposite.
Rather than raising a pool of money in advance from the big banks to
cover the cost of a bailout, the bill proposes that large banks would
be assessed a special fee only after a failure.

To see how strange this is, suppose Citigroup
or some other major bank collapsed, requiring $100bn to pay off
creditors. (We actually should not need a penny to pay off anyone other
than insured depositors if we were serious about the banks not being
too big to fail.) Either the failed bank was acting as a rogue
institution, engaging in behaviour that was far more reckless than its
peer institutions, or it was doing the same thing as everyone else.

In
the first case, would it make sense to tax the other large banks $100bn
because Citigroup acted recklessly? If the recklessness of one bank had
led to its collapse in an environment where its competitors are sound,
this would imply that there had been some serious failures of
regulation. Why would we tax other large banks because the Fed, the
FDIC and/or other regulatory bodies had failed in their job?

Alternatively,
suppose Citigroup collapses because it was doing the same thing as
other banks, but was just slightly more reckless or unlucky. In this
situation, which is similar to the one we faced last fall, all of the
banks would be severely stressed. It would be impossible to hit them
with a special fee. Could we have slapped a special fee on Citigroup
and Bank of America last autumn to have them cover the cost of the
failure of Lehman Brothers? At the time, imposing any significant fee
would have almost certainly pushed several more banks to insolvency.

The
bottom line is that this bill is almost certain to leave the taxpayers
holding the bag for future bailouts. Even worse, it does nothing about
the moral hazard created by having institutions that are too big to
fail. There is nothing in the bill to lead creditors to believe that
the government will not make good on their loans to Goldman, JP Morgan
and the other banking behemoths.

There is a large and growing consensus across the political spectrum for breaking up banks that are too big to fail.
Advocates of this position include former Federal Reserve Board
chairmen Paul Volcker and Alan Greenspan; Sheila Bair, the current head
of the FDIC; and Simon Johnson, the former chief economist of the
International Monetary Fund. There is no reason that we need financial
institutions that are so big that they cannot be safely unwound without
large commitments of government money.

The only people who seem
to stand outside this consensus are those who hold power and are
steering the process of financial reform. This is largely the crew
whose regulatory failures gave us the current disaster. If they cannot
learn from their mistakes then someone else will have to drive the
reform process.