James Bullard, the President of the St. Louis Federal Reserve, has become the second regional bank President in the last couple months to endorse the concept of breaking up large banks.
“We do not need these companies to be as big as they are,” Bullard said. His remarks come a week after J.P. Morgan Chase & Co. disclosed a $2 billion trading loss.
“We should say we want smaller institutions so that they can safely fail if they need to fail,” he said, although he also called J.P. Morgan “a good player.”
I don’t care who’s a good player or a bad player. You get to a point where a large financial institution cannot properly manage their risk, and they will inevitably benefit from a taxpayer bailout, which gives them no reason to even try to calibrate that risk.
I believe in breaking up big banks for a variety of reasons. One, the implicit subsidy of too big to fail gives an enormous competitive advantage to big banks over smaller ones. Two, megabanks garner so much political power and influence as to create terrible policies that cater to them at the expense of ordinary workers and the economy, with the type of sclerotic results we’ve seen, not only in this recovery, but over the last few decades relative to the previous era. In addition, outsized policies benefiting the financial sector often bleed into outsized policies benefiting the rich, and there is ample research that the subsequent inequality created drives financial crises.
Three, there is no social good created by giant banks; in fact, the returns diminish after a certain point. The Cleveland Federal Reserve just published a new study on the social costs and benefits of “too big to fail” banks. John Boyd and Amanda Heitz of the University of Minnesota conclude that “the cost to the economy as a whole due to increased systemic risk is of an order of magnitude larger than the potential benefits due to any economies of scale when banks are allowed to be large. When distributional and inter-generational transfer issues are taken into account, the potential benefits to economies of scale are unlikely to ever exceed the potential costs due to increased risk of financial crisis.” Bigger banks took the risks that caused the crisis in 2008, the report finds, and only after the resulting financial meltdown did small and medium-sized banks experience problems.
To briefly summarize our findings, they show that even under these extreme assumptions, the social costs of TBTF banks substantially exceed the benefits. Thus, our results may be interpreted as supporting the case for breaking up these institutions. If the reader believes that TBTF is only one of several factors leading to the crisis, we make probability calculations showing how large the role of TBTF banks would have to have been such that the costs and benefits were equated. Our results show that if the policy of TBTF increases the crisis probability by even a modest amount then the costs of the policy exceed the benefits.
Four, and this relates back to the problem of political power and influence, a social corrosiveness emanates from the fact that megabanks can engage in whatever policies they want without accountability or even the prospect of financial ruin. You cannot read this story about a suicide after a foreclosure horror story and believe that the ideals hammered into American youths of hard work and fairness play any role in the modern economy. This carries the potential for mass social unrest and a backlash from elites that could easily turn brutal – just look at the police state tactics used against Occupy Wall Street.
So when people say that they don’t agree with breaking up banks because smaller banks taking on the same risk can bring down the economy as well, they’re not looking at these intangibles closely enough. The truth is that too big to fail is not just a handy expression but a central crisis that the political class has not yet figured out how to solve. But if regional Fed presidents can get it, I have hope that we’re moving to a better place.