Break Up the Banks

This article appeared in the April 5, 2010 issue of the National Review.

It's politics, not economics, thatmade them behemoths

Big banks are bad for free markets. Far from being engines of free enterprise,they are conducive to what might be called "crony capitalism," "corporatism," or,in Jonah Goldberg's provocative phrase, "liberal fascism." There is a free-marketcase for breaking up large financial institutions: that our big banks are theproduct, not of economics, but of politics.

There's a long debate to be had about the maximum size to which a bank should beallowed to grow, and about how to go about breaking up banks that become too large.But I want to focus instead on the general objections to large banks.

The question can be examined from three perspectives. First, how much economicefficiency would be sacrificed by limiting the size of financial institutions?Second, how would such a policy affect systemic risk? Third, what would be thepolitical economy of limiting banks' size?

It is the political economy that most concerns me. Freddie Mac and Fannie Maerepresent everything that is wrong with the politics of big banks. They acquiredlobbying prowess, their decisions were distorted by political concerns, and theywere bailed out at taxpayer expense. All of these developments seem to beinevitable with large financial institutions, and all are deeply troubling to thosewho value economic freedom. Unless there are tremendous advantages of efficiency orsystemic stability from having large banks, their adverse effect on the politicaleconomy justifies breaking them up.

If we had a free market in banking, very large banks would constitute evidencethat there are commensurate economies of scale in the industry. But the reality isthat our present large financial institutions probably owe their scale more togovernment policy than to economic advantages associated with their vast size.Freddie Mac and Fannie Mae were created by the government, and they alwaysbenefited from the perception that Washington would not permit them to fail -- aperception that proved accurate. Similarly, large banks were viewed as "too big tofail," which gave them important advantages in credit markets and allowed them togrow bigger than they otherwise would have. In 2007 and 2008, Lehman Brothers wasable to obtain substantial short-term credit from what otherwise would have beenrisk-averse money-market funds, notably the Reserve Primary Fund, which "broke thebuck" after Lehman's collapse, greatly intensifying the subsequent financial panic.It is difficult to view Reserve Primary's large position in Lehman debt as anythingother than a bet that the government would engineer a bailout. It probably wouldhave parked its funds elsewhere had Lehman been considered small enough to fail.

Other policies in recent decades have subtly favored big banks. The governmentencouraged the boom in securitization, for instance, which helped swell the size of financial firms and was stimulated by banks' desire to skirt capital-requirementrules. And the credit-rating agencies' outsized role in financial markets --indeed, the very existence of a small, powerful cabal of federally approved ratingagencies -- was the work of regulators. Such policies fostered large financialinstitutions such as AIG, which built its huge portfolio of credit-default swaps onthe basis of Triple-A grades from the credit-rating cartel.

Turn now to the question of efficiency: Is bigger better for consumers? Bankersspeak mystically about the "financial supermarket" and claim that there aretremendous economies of scope in financial services, meaning that a consumerbenefits from being able to have a checking account and a stock portfolio at thesame large firm. But in practice, whatever benefits might be derived from such asupermarket are probably more than offset by the diseconomies of managing such acomplex entity.

Another unsound argument is that large banks are needed to finance largemultinational firms. If large international firms require big capital investments,these can be obtained by issuing securities or by loan syndication, in which therisk of borrowing is spread across several banks. The existence of large non-bankfirms does not imply the need for similarly gigantic banks.

There are economies of scale, but small banks can take advantage of them, too.For instance, a small bank can join an ATM network or contract with a third partyto develop Internet services. It does not have to build such systems from scratch,and we do not need big banks to make them possible.

Which brings us to the question of systemic risk. Regulation can, of course,make systemic risk worse: The U.S. banking crisis of the 1930s was exacerbated bythe fact that banks could not start new branches across state lines or, in manycases, even within the same state. This led to poor diversification of regionalrisk. The regulation in question was admittedly poor, but we need not return to thebanking system of the 1930s to achieve a reduction in the size of America's largestbanks.

Some point out that the Canadian banking system performed relatively well duringthe financial crisis, noting that Canada's assets are concentrated in just fivelarge banks. This is offered as evidence that large banks are conducive tofinancial stability. But while Canada's big banks have a big share of the country'sassets, they still are much smaller than America's largest banks: Bank of Americaand JP Morgan Chase are three or four times the size of the Royal Bank of Canada,Canada's largest. And while its banking marketplace is dominated by five bigplayers, Canada's population is less than one-seventh that of the United States;even if we concede that Canada is served well by five large banks, the equivalentin the United States would be 35 large banks. In 2008, total assets of the U.S.banking system were about $10 trillion, with the top five bank holding companies inpossession of $6 trillion. If the entire $10 trillion had been divided evenly among35 banks, none would have accounted for more than $300 billion in assets; all ofour banks would have been smaller than the fifth-largest Canadian bank.

Overall, there is little evidence that really big banks are necessary to a soundfinancial system. The financial crisis demonstrated that they are not sufficientfor a sound financial system. And it is possible that without very large banks thesystem actually would be more robust. Certainly, the failure of any one bank wouldbe less traumatic if the size of that bank were small relative to the overallmarket.

I am not optimistic that there is an easy cure for financial fragility even ifwe break up the banks. To the extent that they share exposure to the same riskfactors, a system with many small banks could be just as vulnerable as a system with a few large ones. The fundamental sources of financial risk -- includingleverage, interest-rate risk, exchange-rate risk, and speculative bubbles -- have away of insinuating themselves regardless of the banking industry's structure and inspite of the best intentions of regulators. But while no one can promise thatbreaking up large banks would make the financial system safer, it would withoutquestion make it less corporatist. Which returns us to the question of politicaleconomy.

In the United States, big banks provide an invitation to mix politics andfinance. Large financial firms get caught between public purposes imposed on themby Congress and the interests of private stakeholders. If they do not maintain goodrelations with legislators, they risk adverse regulation. Therefore, it behoovesthem to shape their regulatory environment. And they have done so. In recentdecades, the blend of politics and banking created a Washington-Wall Streetfinancial complex in the mortgage market. This development, and its consequences,have been well documented. Michael Lewis's 1989 book Liar's Poker includes aportrayal of the political exertions of investment bankers to enable mortgagesecuritization to take off. "The Quiet Coup," an article by Simon Johnson thatappeared in the May 2009 issue of The Atlantic, chronicles the rapid accrual ofprofits and power by large financial institutions over the past 30 years; duringthis period, Wall Street firms were able to shape the basic beliefs of politicalfigures and regulators, a phenomenon that Brookings Institution scholar DanielKaufmann has dubbed "cognitive capture." Andrew Ross Sorkin's Too Big to Fail,which describes the response of the Federal Reserve and Treasury to the financialcrisis, leaves the distinct impression that senior bankers had much more access toand influence over Washington's decision makers than did career bureaucrats.

Notwithstanding the good intentions of policymakers, who no doubt plan to createa stronger regulatory apparatus going forward, large banks will inevitably have toomuch power for the apparatus to govern them. They will shield themselves from itsattentions by making political concessions on lending practices. So long as bigbanking is conjoined to big government, that is, we risk a return to the regime ofprivate profits and socialized risk.

I would prefer a completely hands-off policy when it comes to financial markets,but the political reality is that deposit insurance and regulation are not goingaway. Given that they are not, the worst possible outcome is that the marriage ofpolitics and finance evolves into outright corporatism, as it did with Freddie Mac,Fan nie Mae, and the rest of the nation's largest financial institutions. And thatevolution is directly attributable to the influence that comes from banks' beingbig enough to achieve real political power. To expand free enterprise, shrink thebanks.