13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (37 page)

I don’t think merely raising the fees or capital on large institutions or taxing them is enough. I think that’ll—they’ll absorb that; they’ll work with it; and they will still be inefficient; and they’ll still be using the savings.

So I mean, radical things, as you—you know, break them up, you know. In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that’s what we need.
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The reasons to break up the big banks are simple. If there are no financial institutions that are too big to fail, there will be no implicit subsidies favoring some banks as opposed to others; creditors and counterparties will play their necessary role of ensuring that banks do not take on too much risk; banks will be less likely to engage in the excessive risk-taking that could cause the next financial crisis; and banks that do fail will not have to be bailed out at taxpayer expense. Additional regulations preventing banks from abusing their customers or exploiting loopholes to minimize their capital requirements are also necessary, of course; we do not want to relive the savings and loan crisis of the 1980s, when thousands of banks failed due to excessive risk-taking and inadequate supervision. But breaking up the big banks will help level the playing field and make the financial system better able to withstand the next crisis.

Opponents argue that big banks provide benefits to the economy that cannot be provided by smaller banks. A common argument, put forward by Dimon, Scott Talbott of the Financial Services Roundtable, and finance professor Charles Calomiris, is that large corporations require financial services that only large banks can provide.
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Related to this is the idea that the global competitiveness of U.S. corporations requires that American banks be at least as big as anyone else’s banks. Another argument is that large financial institutions enjoy economies of scale and scope that make them more efficient, helping the economy as a whole. Finally, supporters argue that large, global banks are necessary to provide liquidity to far-flung capital markets, making them more efficient and benefiting companies that raise money in those markets.

These arguments suffer from a shortage of empirical evidence. Large multinational corporations have large, global financing needs, but there are currently no banks that can supply those needs alone; instead, corporations rely on syndicates of banks for major offerings of equity or debt. For example, Johnson & Johnson used eleven banks to manage its most recent debt offering in 2008 (and thirteen banks for the offering before that, in 2007).
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And even if there were a bank large enough to meet all of a large corporation’s financial needs, it would defy business logic for that corporation to restrict itself to a single source of financial services, instead of selecting banks based on their expertise in particular markets or geographies. In addition, U.S. corporations already benefit from competition between U.S. and foreign banks, which can provide identical financial products; there is no reason to believe that the global competitiveness of our nonfinancial sector depends on our having the world’s largest banks.

There is little evidence that large banks gain economies of scale above a very low size threshold. A review of multiple empirical studies found that economies of scale vanish at some point below $10 billion in assets.
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The 2007 Geneva Report, “International Financial Stability,” co-authored by former Federal Reserve vice chair Roger Ferguson, also found that the unprecedented consolidation in the financial sector over the previous decade had led to no significant efficiency gains, no economies of scale beyond a low threshold, and no evident economies of scope.
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Finance professor Edward Kane has pointed out that since large banks exhibit constant returns to scale (they are no more or less efficient as they grow larger), and we know that large banks enjoy a subsidy due to being too big to fail, “offsetting diseconomies must exist in the operation of large institutions”—that is, without the TBTF subsidy, large banks would actually be less efficient than midsize banks.
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As evidence for economies of scope, Calomiris cited a paper by Kevin Stiroh showing that banks’ productivity grew faster than the service sector average from 1991 to 1997, “during the heart of the merger wave.”
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However, the paper he cites, and other papers by Stiroh,
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imply or argue that the main reason for increased productivity was improved use of information technology—not increasing size or scope.

There is an element of truth to the argument that large banks are necessary in certain types of trading businesses such as customized (over-the-counter) derivatives, where a corporate client may want a hedge that spans multiple markets (currencies, interest rates, and jet fuel, for example). To manufacture such a hedge cheaply, a derivatives dealer has to have significant trading volume in each of the underlying markets, which implies some minimum efficient scale. However, this alone cannot explain the enormous growth in leading investment banks over the last ten years. Goldman Sachs, for example, grew from $178 billion in assets in 1997 to over $1.1 trillion in 2007,
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while Morgan Stanley grew from $302 billion to over $1.0 trillion.
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Despite the widespread assumption in both New York and Washington that big banks provide societal benefits, there is no proof that these benefits exist and no quantification of their size—certainly no quantification sufficient to show that they outweigh the very obvious costs of having banks that are too big to fail. Instead, defenders of the status quo portray our current banking system, despite its obvious failures, as a fact of nature that must be accepted, and that at best we can hope to tame through better regulation—despite the unquestioned failure of regulation in the decades leading up to the financial crisis.

It seems likely that any financial reform legislation will largely conform to the Obama administration’s approach of tightening regulation of large financial institutions without tackling the underlying problem: the existence of TBTF institutions. It is possible that new legislation will empower regulators to take corrective action against such firms. In the House of Representatives, an amendment introduced by Paul Kanjorski would give the proposed Financial Services Oversight Council the power to order a TBTF institution to cut back its activities or divest some of its assets.
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The bill introduced by Christopher Dodd in the Senate similarly allowed the new Agency for Financial Stability and the new Financial Institutions Regulatory Administration to prune back institutions that pose a risk to overall financial stability.
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Even if some version of this provision survives into the final bill, it will be hedged in by conditions; for example, in the Kanjorski Amendment, the treasury secretary must approve any action that would result in a divestiture of $10 billion in assets, and the president effectively must approve any divestiture of more than $100 billion in assets. More important, there will be no requirement for the regulators to take action. Given the political constraints, it is unlikely that these powers would actually be used to significantly reduce the size and riskiness of megabanks.

Whatever the final form of the legislation, the problem of too big to fail will probably remain with us. But this does not mean that it cannot be solved. It only means that it may take several years, and several sessions of Congress, to solve.

The solution must be economically simple, so it can be effectively enforced; the more complex the scheme, the more susceptible it is to regulatory arbitrage, such as reshuffling where assets are parked within a financial institution’s holding company structure. And the solution must change the balance of political power, so it will last.

The simplest solution is a hard cap on size: no financial institution would be allowed to control or have an ownership interest in assets worth more than a fixed percentage of U.S. GDP.
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Determining the exact percentage is a technical problem that we do not claim to have solved, but the problem can be simply stated: the percentage should be low enough that banks below that threshold can be allowed to fail without entailing serious risk to the financial system. As a first proposal, this limit should be
no more than 4 percent of GDP,
or roughly $570 billion in assets today. U.S. banks could choose to operate globally or only in the United States, but in either case the size limit would be set relative to the U.S. economy, and offshore activities would count toward the limit. (U.S. subsidiaries of foreign banks would also have to comply with the size cap and with all U.S. financial regulations.) Existing megabanks would have to break themselves up in a way that maximizes value to their shareholders; the resulting smaller institutions would be free to compete fiercely for customers and profits.

Hard limits on the size of financial institutions have a precedent. Since 1994, the United States has had a rule prohibiting any single bank from holding more than 10 percent of total retail deposits—an arbitrary cap designed to prevent any one entity from becoming too central to the financial system. This rule had to be waived in 2009 for JPMorgan Chase, Bank of America, and Wells Fargo, demonstrating how recent growth and consolidation have rendered our previous safety measures obsolete.
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An overall asset cap is a necessary condition for financial stability, but it is not a sufficient condition. The acute phase of the recent crisis was triggered not by mammoth commercial or savings banks, although some of them collapsed or nearly collapsed during the crisis, but by (modestly) smaller, risk-seeking investment banks; Bear Stearns had only $400 billion of assets at the end of 2007.
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Because a financial institution could load up on $570 billion of the riskiest assets it can find, there must also be lower limits for banks that take greater risks, and these limits must take into account derivatives, off-balance-sheet positions, and other factors that increase the damage a failing institution could cause to other financial institutions. That way financial institutions that engage in riskier activities will have to be smaller than institutions that hold safer assets, in order to limit the collateral damage their failure could cause. This will require a technical formula that goes beyond the scope of this book,
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but again the goal is simple: all banks, including risk-seeking ones, should be limited to a size where they do not threaten the stability of the financial system. As an initial guideline, an investment bank (such as Goldman Sachs) should be effectively limited in size to
2 percent of GDP,
or roughly $285 billion today. (If it were to choose a riskier mix of activities in the future, its effective maximum size would fall accordingly.)

Determining where to set these limits is a problem shared by all parties to this debate. Every proposed solution assumes that regulators have some way of identifying TBTF institutions so that they can take special precautions against them—which means that there must be a way of calculating the systemic importance of different institutions. If the problem is simply and clearly stated—establish limits such that no bank is too big or too important to fail—it can be solved by people with access to the right data about the financial system. These limits should not be set by regulatory agencies, which could then nudge them upward as memories of the crisis fade and faith in free markets returns. The limits should be set by Congress, with sufficient expert input, and then enforced by regulators.

To be clear, size limits should not replace existing financial regulations. A world with only small banks, but small banks with minimal capital requirements and no effective oversight, would not be dangerous in the same way as today’s world of megabanks, but it would be dangerous nonetheless; it was the collapse of thousands of small banks that helped bring on the Great Depression. More generally, it would be naive to assume that we can predict today all the ways that financial institutions will find to take on more risk and get into more trouble. Therefore, enhanced capital requirements and closer prudential regulation, as proposed by the Obama administration, are also necessary. Size limits, however, provide protection against both the systemic risk and the competitive distortions created by financial institutions that are too big to fail, which are not adequately addressed by existing regulations. We believe these limits should work out to no more than 4 percent of GDP for all banks and 2 percent of GDP for investment banks, but that is a debate we are willing to have.

Why 4 percent and 2 percent? The fundamental tradeoff is between safety and efficiency. A lower size limit makes the financial system safer, because it will be less vulnerable to the failure of a single bank or a handful of banks; however, draconian size limitations could introduce unintended consequences if, for example, investment banks are no longer able to maintain sufficient trading volume in global markets. Personally we would prefer even lower limits, for two main reasons. First, Bear Stearns had only $400 billion in assets—implying that, for a risk-loving investment bank, $285 billion may still be large enough to threaten the financial system. Second, lower limits would increase competition and reduce the potential political power of any single company.