The Rational Argumentator

A Journal for Western Man

Too Big to Fail

What to do with banks that are "too big to fail?"
 
When President Bush and Treasury Secretary Hank Paulson first concocted TARP, one argument against it was that it would create a moral hazard problem, that by bailing out banks that took on high risk for high profits, we'd only be encouraging more of such behavior in the future.  TARP supporters responded that it wasn't the time to be worrying about such things, and the banks were bailed out.  These banks are now bigger, more profitable, and expanding their trading operations, not their lending, confirming the fears of those of us who opposed the TARP.  We're back on the road to another round of banking crisis.  What to do about banks "too big to fail?"
 
No government will allow a collapse of a bank if it threatens a system-wide meltdown.  So let's immediately remove "let 'em collapse when they get in trouble" from consideration.  We need some way to reduce the probability of future crises.
 
In his recent remarks on financial reform, President Obama argues for separation of banking from other kinds of financial activities (operating hedge funds and private equity funds, derivatives trading, and the like).  Currently the taxpayer subsidizes banking by providing federal deposit insurance; thus the taxpayer bears risks, makes capital less expensive for banks, and – in the event of losses – can end up eating them.  It's the "privatize the profits, socialize the losses" game.  Since taxpayers share some of the risk, a bank has an increased incentive to take on riskier, potentially higher return activities.  In the absence of an constraint, they’ll do so.  President Obama's proposed solution?  Impose some constraints.
  
President Obama: "It's for these reasons that I'm proposing a simple and common-sense reform, which we're calling the 'Volcker Rule' – after this tall guy behind me.  Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.  If financial firms want to trade for profit, that's something they're free to do.  Indeed, doing so – responsibly – is a good thing for the markets and the economy.  But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people."
 
The President has correctly identified a genuine problem, and proposed a solution that at first blush makes sense.  But...
 
1. The firms that figured most prominently in the Spring and Fall 2008 crisis were not banks.  Think Bear-Stearns, Lehman, AIG, Goldman Sachs.

2. The problem isn't so much speculation as it is "too big to fail" (TBTF).  So long as a distressed entity is deemed TBTF, it will be bailed out, never mind FDIC and similar programs.  Think GM and Chrysler.

3. What's a bank, anyway? Think Goldman Sachs.  When Goldman got into trouble, it was allowed to change its status from a financial holding company to a banking company and hence qualify for direct taxpayer protection (instead of the "under the table" sort of support it had previously been receiving from Treasury, e.g. the bailout of AIG, on which Goldman gave Paulson advice, and in which Goldman was the biggest beneficiary).  And then, once it found bank status too constraining, it turned itself back into a financial firm.  (Financial firms are subject to less stringent requirements than banks regarding risk and capital.)  If a firm can morph from one status to another almost at will, then defining separate rules for each type is wasted effort.
 
Obama also proposes tighter controls on non-banking financial activities  But this also misses the point: too big to fail is equivalent to too big to behave responsibly.  I suspect there's almost no chance of getting regulators who could oversee TBTF firms to ensure honesty and transparency.  The advantage lies with the big firms.  And there's almost no chance of a regulatory process not becoming a political prize to be fought over by industry, by Congress, and other special interests.  "Regulation" in the sense of external checks to enforce honest accounting and transparency is absolutely necessary; regulation in the sense of external managements and second guessing of business decisions is not, and is harmful.
 
Here's a very nice piece from New York Times that concisely sums these points.  (Might require free registration.)
 
There is a solution that's quite different from the one being proposed by the President.  First, break up the biggest of the banks and bank type firms.  "Break up" means, of course, split them into smaller, independent firms.  These would still be large banks.  Second, develop bankruptcy procedures suitable for handling these large banks, and make certain FDIC is equipped to implement them.
 
Keep in mind that these firms are in part creations of government intervention, protection and subsidy.  So long as they remain too big to fail they'll be too big to behave responsibly.  We'd be better off with a system of smaller, more competitive banks.
 
This barely gets at the issue of what needs to be done to clean up our financial system.  But ending TBTF would be a start.

"Break up the banks?!  Doesn’t this go against your free market principles?"
 
No, it doesn’t.  I’m not trying to answer the question "What would be the ideal long run solution, the best outcome you can imagine?"  I'm answering the question "Given where we are now, what could we propose that would (1) reduce the chances of further financial crises, and (2) actually have a chance of being implemented?"
 
Advocates of free markets often make the error of conflating "private" with "free market."  Our current financial system is largely private, but also includes substantial government participation; the Federal Reserve and the Treasury Department are the two most important examples.  In the status quo, big financial institutions and Fed/Treasury are closer to being partners than opponents, and it’s not always obvious who is subordinate.  In the economics of regulation, "regulatory capture" refers to the problem of a regulated industry dominating the agency that regulates it, and then shaping policies so as to boost net returns and insulate itself from competition.  It's not a new problem: Adam Smith's Wealth of Nations was directed in large part at exposing the dangers of this kind of system (properly called mercantilism).
 
Our interventions in the financial crisis have had the effect of increasing the size of the biggest banks, reinforcing their expectations of government bailouts in times of trouble, and encouraging more of the same behavior that put the financial system in jeopardy in the first place.  It’s hard to argue that these are simply unintended consequences of interventions by ignorant government regulators – Treasury is staffed by once and future bankers, for example.  Evidence?  See this piece, and this piece, and this one.  For a recent example of the consequences see this.
 
(Of course, every member of Goldman or similar firms who joins Treasury must sign a pledge to recuse* him/herself from making decisions in which his/her former employer would have an interest.  I’m sure these paper pledges are at least as good as the CDOs Goldman sold AIG, so perhaps my worries are overblown.)
 
I have little sympathy for these large financial firms.  It's a mistake to romanticize them as bold entrepreneurs looking for new and better ways to serve consumer needs.  A better characterization is well-connected mercantilists, who gain from exploiting government connections.  Like the mercantilist monopolists Adam Smith opposed, they still provide genuine services and do create value, and it’s also a grave error to simply demonize large banks per se.  But under our status quo, it looks very much like the firms are simply exploiting their political connections to engage in what 19th Century political economist Frederic Bastiat called "legalized plunder" of the taxpayers.  

To be continued...

* Recuse: The spellchecker in the latest version of MSWord doesn't recognize this verb, but I found it in a very old dictionary.  It means "to withdraw from a position of judging so as to avoid any semblance of partiality or bias."  What a remarkable concept!  It must date from an ancient time when people actually cared about these things.

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