There has been a lot of discussion about bringing back Glass-Steagall and breaking up the big banks. Given that the only bank merger before this crisis that would have been stopped by Glass-Steagall was Citigroup, and it was allowed to happen prior to repealing Glass-Steagall via a special act of Congress, I’ve never been convinced. The most important thing Glass-Steagall would have prevented was the post bailout mergers (and Goldman becoming a bank holding company), but those would likely have also been permitted under special exemptions from congress since most of the mergers were arranged by the government itself. Still, such solutions are currently in style. Fed Governor Daniel Tarullo offers his take on it.
Unfortunately, I think he mischaracterizes the problem a bit:
The concern is hardly a new one. In one manifestation, too big to fail was an extension of the classic problem of bank runs and panics. If a large bank failed—whether because it was illiquid after a deposit run or insolvent after severe losses—the entire banking system might be endangered. In cases in which other banks held significant deposits in the distressed institution, the failure of a large bank might lead directly to the illiquidity or insolvency of other banks. The result could be a domino effect in the interbank lending market, with one bank’s failure toppling the next. Even where direct losses to other banks were thought manageable, the failure of a large bank might strike panic into depositors, especially uninsured depositors, of other large institutions. The result might be a far-reaching run on the entire banking system that could, in a worst case such as occurred in early 1933, freeze the financial system completely.
This “classic” problem has a number of solutions, some more palatable than others. Two are worth discussing because they are generally considered the best. The first is a higher reserve requirement. For many account types, the reserve requirement for banks is zero, effectively granting individual banks the ability to generate as much money out of thin air as they want (checking account “sweeps,” for example). The second solution is deposit insurance. Though most banks did not pay their premiums for deposit insurance for 10 years, the FDIC deposit insurance fund is backed by the US Government, and no depositor really worries about losing money. It is only the “hot-money,” or brokered accounts, that flee when deposit insurance is in place (hot money always flees, so it’s stupid to have a system where it matters anyway). This problem is simply addressed by the first solution, requiring higher reserves for brokered deposits. Tarullo mentions the second solution, but completely ignores the first solution, which is rather scary, because reserve requirements are determined by the Fed Governors. Honest accounting and high reserves are not an option the banks and the Fed are considering.
Continuing, though, Tarullo mentions the problems with the currently proposed solutions:
One approach suggested by a number of commentators is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with non-bank financial firms. The idea is presumably to insulate insured depository institutions from trading or other capital market activities that are thought riskier than traditional lending functions. There are, however, at least two reasons why this strategy seems unlikely to limit the too-big-to-fail problem to a significant degree. One is that, historically at least, some very large institutions got themselves into a good deal of trouble through risky lending alone. Moreover, as we have already seen in the experience with Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to-fail threat.
Another approach would be to attack the bigness problem head-on by limiting the size or interconnectedness of financial institutions. Some observers have even suggested that existing large firms should be split up into smaller, not-too-big-to-fail entities, in a manner a bit reminiscent of the break-up of AT&T in the early 1980s. Of course, the conceptual and practical challenges in breaking up the nation’s largest financial institutions would be considerably more daunting than those faced by Judge Greene in creating four regional operating companies and a long distance carrier out of the old AT&T. Indeed, to my knowledge, no one has offered anything like standards for undertaking this task, much less a blueprint for how it would be accomplished. This is, in other words, more a provocative idea than a proposal. Like many a provocative idea, though, even in an unelaborated form it can focus attention on the relative effectiveness of alternative policy proposals.
I agree with Tarullo, though I worry that his arguments are a little weak. It seems to me that he discounts the proposed solutions because they would be difficult to implement and aren’t yet planned with enough detail. It’s as if he’s claiming that hard work is all that stands between us and a stable financial system. In reality, there are structural issues that would make the proposed solutions equivalent to burning the system to the ground and starting over. The purpose of the bailouts was that we didn’t want to wait for a phoenix to rise from the ashes.
What I don’t expect a Fed Governor to say is the real reason we can’t split these companies. Splitting the big banks could cause the systemic collapse they are trying to avoid. There are also a lot of facts unknown to the public, such as how unhealthy the banks really are. Splitting a company is always an entertaining way of finding out where the crap is. Regarding these unknowns, we have learned a few things in the last week. We’ve learned that some of the collateral at the Federal Reserve includes worthless assets, such as bonds from bankrupt companies, empty malls, and other garbage. The Fed’s purported inability to remove liquidity from the system doesn’t offer hope that the rest of the balance sheet is any better. The possibility of total collapse gives me some interest in the proposals even if I would oppose them on principle under normal circumstances.
Tarullo’s proposed fix can be described as a lot of mutually reinforcing tweaks to the current system. He concludes:
Of course, financial instability can occur even in the absence of serious too-big-to-fail problems. Other reform measures—such as regulating derivatives markets and money market funds—are thus also important to pursue. In focusing today upon measures to mitigate too-big-to-fail problems, I mean only to suggest that no reform package should be considered sufficient if it does not address these problems in a robust fashion. And in suggesting that policymakers should continue to examine possible measures beyond the current reform agenda, I certainly do not intend to suggest that the current agenda should be delayed. I only urge that we all keep the too-big-to-fail problem front and center as the regulatory reform effort moves forward.
It is important to recognize that our banks are a government sponsored cartel. The government grants them a lot of special privileges and protects them from competition. In return, the government requires that they try not to blow up the economy very often. How does the government enforce this? By passing any legislation that the banks like. Take the recent legislative efforts, which may weaken existing regulations while claiming to crack down on bad behavior. Pretty impressive, huh? I do sympathize with the legislators. They have lots of things to do, while the bankers are paid lots of money to find and exploit loopholes. When you pay a lot of people a lot of money to solve a puzzle, they tend to solve it. This is especially true if you pay them to help design the puzzle in the first place.
