We Need Smaller Banks

Back at the beginning of the twentieth century there was an important dispute about “trusts”—large business enterprises with monopoly power. One side thought the thing to do was bust the trusts—break them up and eliminate monopoly power. Another thought we should just regulate the trusts. In a number of fields we eventually did shift to the regulated monopoly system, and I think the evidence is that it wasn’t very effective. What’s sometimes called the “deregulation” of the telecommunications and airline sectors in the 1970s was really the joint deregulation and de-monopolization of these sectors, and it’s been a good thing.

But as applied to other fields, “deregulation” has meant other things. The financial sector was, prior to deregulation, extremely segmented. Deregulation has mostly meant, in practice, removing the regulatory impediments to consolidation and growth in firm size. And consequently, many firms have gotten big indeed. So big that they’re “too big to fail.” But beyond being “too big fail,” there are fairly compelling arguments—see this, for example, from Economics of Contempt—that they’re also too complicated to nationalize or take into receivership. This is, everyone things, a situation that has to end.

There are three main kinds of things that can be done to prevent us from getting into this problem again: Regulate size, regulate risk, and regulate failure.

As best one can tell, the administration is currently pursuing a strategy that’s based on the second and third options. They’re imagining something like the old airline industry, in which a handful of large players operate from a privileged position (in this case, government guarantees) but subject to heavy regulation. They’d also like a rewrite of laws such that there’s a way to manage a post-failure takeover. I think all this is fine, but option two is very unlikely to work over the long term. Calculated Risk observes that even if the Fed had earlier been specifically tasked with regulating systemic risk that wouldn’t have accomplished anything—the Fed was led by people who didn’t believe there was a problem: “How would a systemic-risk regulator help if they miss the problem?” This is a point I’ve made over-and-over again. Our problem was more fundamental than flawed rules, it was flawed leaders. And I doubt it’s a problem that’ll go away. Regulatory capture is bound to afflict this kind of situation. And the combination of toothless regulation and explicit government guarantees will allow the large institutions to squeeze out the small ones.

Which is why I agree with James Kwak that fundamentally we need some option one. Smaller banks will pose fewer systemic risks. Smaller banks will also be somewhat less effective at capturing regulators. And smaller banks will be easier to clean up when they feel. Indeed, calculated ambiguity about who will and won’t get rescued if there’s a need for a bailout will be easier to maintain with small institutions.