Break Up the Banks
From the April 5, 2010, issue of NR.


Arnold Kling

Big banks are bad for free markets. Far from being engines of free enterprise, they are conducive to what might be called “crony capitalism,” “corporatism,” or, in Jonah Goldberg’s provocative phrase, “liberal fascism.” There is a free-market case for breaking up large financial institutions: that our big banks are the product, not of economics, but of politics.

There’s a long debate to be had about the maximum size to which a bank should be allowed to grow, and about how to go about breaking up banks that become too large. But I want to focus instead on the general objections to large banks.

The question can be examined from three perspectives. First, how much economic efficiency would be sacrificed by limiting the size of financial institutions? Second, how would such a policy affect systemic risk? Third, what would be the political economy of limiting banks’ size?

It is the political economy that most concerns me. Freddie Mac and Fannie Mae represent everything that is wrong with the politics of big banks. They acquired lobbying prowess, their decisions were distorted by political concerns, and they were bailed out at taxpayer expense. All of these developments seem to be inevitable with large financial institutions, and all are deeply troubling to those who value economic freedom. Unless there are tremendous advantages of efficiency or systemic stability from having large banks, their adverse effect on the political economy justifies breaking them up.

If we had a free market in banking, very large banks would constitute evidence that there are commensurate economies of scale in the industry. But the reality is that our present large financial institutions probably owe their scale more to government policy than to economic advantages associated with their vast size. Freddie Mac and Fannie Mae were created by the government, and they always benefited from the perception that Washington would not permit them to fail — a perception that proved accurate. Similarly, large banks were viewed as “too big to fail,” which gave them important advantages in credit markets and allowed them to grow bigger than they otherwise would have. In 2007 and 2008, Lehman Brothers was able to obtain substantial short-term credit from what otherwise would have been risk-averse money-market funds, notably the Reserve Primary Fund, which “broke the buck” after Lehman’s collapse, greatly intensifying the subsequent financial panic. It is difficult to view Reserve Primary’s large position in Lehman debt as anything other than a bet that the government would engineer a bailout. It probably would have parked its funds elsewhere had Lehman been considered small enough to fail.

Other policies in recent decades have subtly favored big banks. The government encouraged the boom in securitization, for instance, which helped swell the size of financial firms and was stimulated by banks’ desire to skirt capital-requirement rules. And the credit-rating agencies’ outsized role in financial markets — indeed, the very existence of a small, powerful cabal of federally approved rating agencies — was the work of regulators. Such policies fostered large financial institutions such as AIG, which built its huge portfolio of credit-default swaps on the basis of Triple-A grades from the credit-rating cartel.