Why We Must Break Up the Banks

It's not often that I disagree with Paul Krugman, but there are occasions where at least one of us is wrong. And the treatment of too big to fail (TBTF) banks is one of them.

Krugman argued in a column last week that breaking up the TBTF banks is not a necessary part of financial reform. Krugman pointed to the example of Canada as a country with a well-regulated financial system. Canada did not experience a financial crisis in 2008 in spite of the fact that five big banks essentially account for the whole of the Canadian banking system. On the other side, Krugman noted that the collapse of large numbers of small banks can also create a crisis, pointing to the chain of bank collapses at the start of the Great Depression.

These are valid points, but to paraphrase Dorothy in the Wizard of Oz: "we're not in Canada anymore." While Canadian banking regulation appears to have been effective thus far (we may want to see how they cope with a yet to deflate housing bubble before pronouncing it a success), Canada is a very different country from the United States. In Canada, they have had universal Medicare for 40 years. As the first President Bush used to say, it is a kinder, gentler, country.

This matters for financial regulation, because there is a level of independence and integrity on the part of the regulators in Canada that does not exist in the United States. The line in Washington is that if you want to talk to someone from Goldman Sachs, call the treasury department.

The close connection between the industry and the regulators matters because regulation will always require judgment calls. It also matters because regulation means limiting bank profits. The regulations are by definition about preventing banks from carrying on lines of business that are profitable.

Going back to the last crisis, our regulators should have cracked down on the junk mortgages that were being issued by the millions to buy homes at bubble-inflated prices. But this would have meant clamping down on banks that were making huge profits issuing the loans. It also would have meant clamping down on the investment banks that were making huge profits packaging them into securities and selling these securities all over the world.

To take an even more extreme case, the recent analysis of the Lehman bankruptcy showed that New York Federal Reserve Bank helped to hide Lehman's insolvency for months. It accepted Lehman's junk as collateral for short-term loans. This was a direct violation of the Fed's charter, which only allows it to accept investment grade assets as collateral, a definition that clearly did not include Lehman's "Repo 105s".

In these cases, our regulators instead used their judgment to decide that everything was just fine and looked the other way. Remarkably, no regulator was fired for these astounding failures in judgment. In fact, there was probably not even a single regulator who missed a promotion.

In the United States it will always be easy for regulators to look the other way, even when the ultimate consequences prove to be disastrous. By contrast, cracking down on politically connected banks is difficult for regulators. The banks' executives will call their friends in the administration and Congress to complain about the crazy regulator who is trying to keep them from running their business.

And, you can be sure that the banks will have a story. They pay smart people lots of money to develop those stories. The banks' mouthpieces will make a conscientious regulator look like a crazed vigilante who just doesn't understand modern finance. Just ask Brooksley Born, the head of the Commodities Futures Trading Commission who was stopped in her effort to regulate credit default swaps back in 1998.

Krugman is right that breaking up the banks does not guarantee good regulation. In addition to his Great Depression example, we also have the savings and loan disaster of the 80s. The S&Ls were overwhelmingly small institutions with even the largest being far below any conceivable TBTF threshold.

However, a break-up of the big banks will at least give the country some hope that things can change. As it stands now, the big banks are back on their feet, and in some cases more profitable than ever, feasting on the now explicit government guarantee of support in the event of a crisis. By my calculations, this guarantee could be worth as much as $34bn a year, more than one-third of the gross cost of the healthcare bill.

There are many aspects of regulatory reform that involve technical issues that the public will not follow. If we have to say what is different the day after financial reform is passed, rules on leverage limits and exchange-traded derivatives will not mean much, especially if they are enforced by people who accept Repo 105s as investment grade collateral.

If we break up Citigroup, Goldman, JP Morgan and the other giants, then we will know that something has changed. This break-up, along with a financial transactions tax, will lead to a qualitatively different financial industry.