The Problem of Big Banks

Stephen G. Cecchetti and Kermit L. Schoenholtz write,

Imagine the following simple approach (like that of Acharya et al). Let the capital structure of a bank’s long-term liabilities be clearly stated and then honored if and when necessary. That is, think of the bank as having a hierarchy of long-term debt ranging from the most senior (call it tranche A) to the most subordinated (tranche Z for zombie!). Whenever a bank’s capital position is deficient – say, because the market value of its equity sinks below a threshold ratio to its book assets – the resolution authority automatically makes some of the debt into new equity, starting with the Z tranche and then climbing up the alphabet until there is sufficient capital to return the bank above the regulatory minimum. Provided that there is sufficient long-term debt to absorb the losses, the concern remains a going one. (The resolution authority could still replace management and shut down risky activities in an effort to prevent a serial failure.)

Pointer from Mark Thoma. This is an alternative to the idea of divesting the firm’s assets according to a “living will.” The authors write,

But let’s not overstate the attractiveness or simplicity of the phoenix plan. No scheme can eliminate policy discretion, as crises often lead governments to change the rules on the fly (think of the 2008 TARP legislation that followed the failure of Lehman).

The way I read this, we really cannot get back to the rule of law if we have too-big-to-fail banks. That is what I will be arguing in two weeks. These institutions will be given special treatment, particularly in a crisis. In 2008, AIG was eviscerated in order to provide a liquidity injection to Goldman Sachs, Deutsche Bank, and others. Does anyone think that the decisions would have come out the same if the Treasury Secretary had been a proud alumnus of AIG rather than of Goldman Sachs?

Some of my other thoughts for the panel.

1. Suppose that we were to limit any financial institution to $250 billion in liabilities that are not backed by capital. Currently, the largest banks in this country seem to have over $1 trillion in liabilities.

2. What can you not do with a $250 billion portfolio? What would such a bank be precluded from doing, other than buying another huge bank?

3. I think it is pretty hard to know for certain the extent of economies of scale and scope in banking. However, my intuition is that the big banks did not get where they are today through natural market competition. In other industries, dominant firms are characterized by focused excellence. Intel is very good at designing and manufacturing chips. Walmart is very good at logistics. What is JP Morgan Chase very good at? Citigroup?

Another characteristic of dominant firms in competitive markets is that they grow by doing more of what they are good at. In contrast, banks grow primarily through mergers and acquisitions.

4. How much does too-big-to-fail matter? Well, try to imagine what the computer industry would look like if the government had designated the dominant firms as of 1970 as too big to fail. We would still have Wang and DEC, but I doubt that we would have Apple or Microsoft.

5. If we imagine banks without TBTF, then it is likely that at times in the past the stock prices of some of the large banks would have been very low, which would have halted their growth through acquisitions and perhaps forced management to divest poorly-managed business lines in order to appease shareholders.

We cannot have large banks without TBTF. We cannot have TBTF without an unfair playing field and mockery of the rule of law. So we should break up large banks.

3 thoughts on “The Problem of Big Banks

  1. Back during the financial crisis, I remember a lot of similar proposals to this ‘phoenix plan’, usually in the form of Contingent Convertible bonds (sometimes reversibly reconvertible) with some clever schemes for what the triggering events and conversion rates would be, and whether they would be marked-to-market or not.

    Many of these seemed to have a lot of merit, but the ideas never went anywhere, and I think it is precisely those merits which turn into demerits in a public choice analysis.

    The problem was that they were designed to be accomplish automatic and market-directed resolution in a way that didn’t involve supervisory regulators and which had a minimal role for the courts in general. But the bureaucracy’s never going to support any guaranteed-solvency scheme that substitutes for their function and automates them out of their jobs and raison d’etre.

    A way out of this would be to retask our bureaucrats with conducting burdensome and expensive investigation and audits at the bank’s expense and with a frequency that is monotonic to a bank’s uncapitalized liabilities, but on an increasingly steep progressive scale. When a bank gets to around $250 Billion, they’ve practically got a regulator sitting permanently in every branch already constantly looking over everyone’s shoulder, and they simply give up trying to grow.

    That ought to please both the bureaucrats and the small-banking advocates.

  2. Off-topic, but you might be interested in this paper: http://www.nber.org/papers/w20569

    An excerpt: “We have presented a model of investment hangover in the Great Recession that combines both Austrian and Keynesian features. On the Austrian side, the recession is precipitated by overbuilding in the residential sector, which necessitates a reallocation of resources to other sectors. The reallocation problem is exacerbated by the durability of residential capital. which prevents depreciation from naturally erasing the overbuilt capital. On the Keynesian side, a lower bound on interest rates slows down reallocation and creates an aggregate demand shortage. The demand shortage can also reduce consumption and investment in sectors that are not overbuilt, leading to a severe recession. Eventually, consumption and investment recover, but the slump in the residential sector continues for a long time.”

  3. This part came off as abstract to me: “unfair playing field and mockery of the rule of law”.

    Nobody cares about the rule of law so long as everything is running smoothly. The reason it’s worth breaking up banks is to reduce the cycle we are in, where there’s a crisis every 20 years or so.

    Likewise, a lot of people might not care if the financial sector used decades-old tools and was not innovating very much. Old and reliable is, in many areas, a good thing.

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