The Paulson/Yglesias Small Bank Plan

Hank Paulson speaking today:

We need to get to the place in this country where no institution is too big or too interconnected to fail. Because regulation alone — and I’m all for more effective, better regulation, more authorities — but regulation alone is never going to solve the problem. There’s no regulator that’s going to be so good that they’re able to deal with it and ferret out the problem. It takes a balance between the right regulatory system and authorities and market discipline.

This seems to me to be in the spirit of what I said last week:

[W]hat’s the deal with banks that are too big to fail?

If we can identify such banks, why not try to make a rule preventing banks from becoming that big? As a tradeoff, banks that rested in the small-enough-to-fail category could be allowed to operate with much, much laxer oversight and regulation since everyone would understand that if they fail they’re going to sink. Presumably, there are some efficiency gains associated with the economies of scale involved in big financial institutions. But there would also be efficiency gains associated with relaxing the regulations on financial institutions. And the only reasonable way to seriously relax those regulations would be to commit to a no-bailouts scenario. But to do that, we need to make sure the banks aren’t too big to fail. So why not focus the regulatory effort on that — on making sure that institutions don’t get so big that they need bailing out?

The difference is that Paulson is the Secretary of the Treasury and I’m just a blogger.

But Paulson’s actual policies seem to me to be pointing in the opposite direction. As we’re propping financial institutions up, we’re also encouraging them to consolidate. Beyond that, the tendency has been for the larger institutions to be the ones in the worst shape. By preventing them from failing, we’re preventing smaller but better-managed institutions from flourishing in their place. The logical endpoint of something like that would be for the entire financial sector to eventually be concentrated in the hands of four or five gigantic multi-purposes financial institutions all of which operate with implicit government guarantees and allegedly tight regulatory oversight that naturally becomes regulatory capture as soon as people stop paying attention.


A better path than the one we’re on would be to first stop spreading money around at random, and start using it to buy common stock, Sweden-style, effectively nationalizing the banks. Then we shutter institutions that are beyond repair and fix the rest. Then when we reprivatize banks, which should be done as quickly as possible, we break them up and sell them as smaller institutions. You then need regulators to, in the future, effectively cap the size of the banks so that no institution reaches a scale whereby we wouldn’t be comfortable allowing it to fail. Whatever efficiencies are lost by preventing really big banks, we can try to offset by giving them more latitude to conduct their business as they see fit.