Brown-Vitter: More Hot Air

Today’s New York Times article by Senators Brown and Vitter (the preview of their much-touted “bank break-up” bill) starts with a very encouraging line: “governments shouldn’t pick economic winners and losers.”

Senator Brown, in particular, seems to have learned this important lesson fairly recently (auto bailout, anyone?). But putting this aside (and also ignoring the ongoing debate about the purported subsidy to large banking organizations, which should be eliminated, if it indeed exists), Senators Brown and Vitter display some disturbing, though not uncommon, misconceptions about U.S. and global banking. And, as is always the case, poorly understood and inaccurate facts create bad policy suggestions.

The first problem is the implicit assumption that large size and diversity of operations are negative traits. In fact, diversity is the key to managing risk in banking. Part of the reason why US banking has had such a checkered history relative to many other countries is because of its historical lack of geographical and product diversity – a result of the long-standing prohibitions on inter-state banking and branch banking and limitations on combining investment and commercial banking activities. One of the single biggest causes of the banking crisis in the late 1920s was a lack of geographical diversity (and, as congressional records show, States that prohibited branch banking fared the worst). Similarly, one of the primary causes of the 2008 financial crisis was a lack of asset diversity - too many banks holding too many securitized sub-prime mortgages.

Second, is the implicit assumption that investment banking and underwriting activity are inherently more risky than loan activities. Certainly, imprudent investment banking can be disastrous. So can making risky loans. And the 2008 crisis was, at its core, a loan origination problem (a fact largely ignored by Congress because of the uncomfortable questions it raises about the two GSE’s - Fannie and Freddie).

Third, is the belief that the 2008 bank bailouts were somehow linked to the FDIC deposit insurance scheme and that if we ‘narrow’ the safety net, all future bailouts will be avoided. I am no fan of federal deposit insurance, but the bailouts were unrelated to it. TARP was a Treasury creation, passed by Members of Congress under extraordinary circumstances. The only way to ensure it doesn’t happen in future is to rein in Congress and limit their ability to (in the words of Brown and Vitter) “pick economic winners and losers”.

As it turns out, the Brown-Vitter Bill is less about bank ‘break-up’ and more a U.S. variant of the FSB’s G-SIFI surcharge – which raises the question why it is necessary at all, except to put the U.S.’s global banks at a disadvantage, even though they are already disproportionately affected by the surcharge. Brown and Vitter’s calls for higher capital requirements are not objectionable per se, but as the ongoing problems with the Basel Accord shows, the devil is always in the details. And if you get it wrong, you risk creating exactly the systemic problems – such as an excessive reliance on sovereign bonds or mortgage-backed securities – that you were trying to avoid.

Essentially, the only way to end the perception of a government backstop is to put in place a credible system to allow large firms to fail if they make poor decisions. To this end, the Brown-Vitter Bill doesn’t add anything except more confusion.