The Corner

Still Too Big To Fail

Simon Johnson argues in the New York Times that the persistent problem of the “too big to fail” banks, highlighted by today’s hearings on JPMorgan and the “London Whale,” means that hard caps on the absolute size of banks should be adopted. Richard Fisher, writing in the Wall Street Journal, takes a similar view, and offers some additional policy prescriptions: limiting the federal safety net to commercial banks, forcing bank creditors to sign written acknowledgments that there is no government guarantee of their loans, and ensuring that the various corporate entities within financial conglomerates are structured in such a way that they can be taken into bankruptcy in a speedy, non-disruptive fashion.

A few thoughts:

First, there is now something like a bipartisan consensus (at least among people who pay attention to the evidence) that Frank-Dodd did not end the problem of TBTF, and that the hundreds of pages of the bill and the thousands of pages of regulation it already has generated have done little or nothing to prevent a reprise of the events of 2008–09. Mr. Johnson worries that “the largest banks have become too complex to manage,” and points to the fact that JPMorgan CEO Jamie Dimon — “one of our supposedly great risk managers” — apparently was unaware what was happening at his bank. But Mr. Johnson does not seem to appreciate that if JPMorgan is so complex that its CEO fails to comprehend important aspects of its business, then it is unlikely that outside regulators, who have neither the insider knowledge nor the financial incentives of the bank’s executives, would find the job any easier. If a bank is too complex for its managers to manager, it is too complex for its regulators to regulate. There is not much currently on offer — not Dodd-Frank, not the Volcker rule — that is going to change that.

Second, the banking debate remains hopelessly (and probably unavoidably) confused about the relationship between two events that are related but are in fact separate events: the credit crisis and the rapid decline in housing prices. It is very likely that the latter would have occurred regardless of the former — it is the nature of bubbles to burst. Nikki Clowers of the Government Accountability Office (an agency with a name that is the source of much mirth for me) in February said that her organization estimated the cost of the financial crisis to be anywhere from a few trillion dollars to more than $10 trillion, and a great deal of that was related to the $50,000 hit that the median household net worth took as the result of plunging housing prices. But have a look (via Mother Jones) at what housing prices did at the turn of the century, and ask yourself whether a steep downturn was baked into the cake:

That line says that somebody was going to take a beating on housing prices. That’s what happens in bubbles. There is more linking the various aspects of our economy together than banks and financial firms, and a couple of trillion dollars in vanished household wealth probably was going to cause a severe recession, regardless of the structure of the banking system. Regulation cannot magic that fact away. There were many contributors to that bubble: The combination of stupidity and rapacity that characterizes the mortgage-lending industry was one, but there were many others, notably federal policies specifically intended to lure more buyers into the market and drive up housing prices, along with a Federal Reserve that responds to every piece of bad news with a flood of cheap money. Most of those policies remain in place.

Third, the bailout critics were right when they argued that TARP et al. would create a political situation in which it would prove all but impossible for the federal government to step away from its implicit support of the TBTF banks, and that the more likely outcome would be calls to regulate them ever more tightly, until they resemble public utilities.

Most sensible observers agree with Mr. Simon and Mr. Fisher that there is a substantial subsidy accruing to the TBTF banks. But telling creditors to sign a piece of paper saying that there is no guarantee does not make that guarantee go away. It just makes bankers and politicians into bigger liars than they already are. If you want the subsidy to go away, let a bank or two fail.

The problem is, pretty much everybody agrees that we can’t or won’t do that. But it does not follow that this calls for binding caps on the size of banks. What is most relevant is not the absolute size of a financial institution but the size of its liabilities relative to the size of its capital. Seriously raising capital requirements on all banks — from the gnats to the Godzillas — would probably go a long toward achieving the same goal without asking some panel of regulators — regulators who already have proven themselves ineffective — to draw a magical line in the sand and say “Everything on the east side of this is too big.” It would also have the added benefit of treating all banks the same way.

The last time we went down the regulatory road, with Dodd-Frank, we ended up with new rules regarding the specifics of disclosing the use of tin and tungsten mined in areas controlled by the Congolese Liberation Army — I wish I were making that up — but failing to solve the fundamental problem. One thing you can be sure of: The markets won’t work properly until we let them work.

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