Breaking Up Large Financial Institutions is the Wrong Response to the Financial Crisis

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Created on Thursday, 29 April 2010 05:00

“Most observers who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies and hurt the competitiveness of the United States…They believe that it would actually make us less stable, because the individual banks would be less diversified and, therefore, at greater risk of failing, because they wouldn’t have profits in one area to turn to when a different area got in trouble.  And most observers believe that dealing with the simultaneous failure of many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.”

- Lawrence Summers, Director, National Economic Council,
PBS NewsHour with Jim Lehrer, April 22, 2010

 

As the Wall Street Journal’s Victoria McGrane recently reported, a group of Democrats in the Senate, led by Senators Sherrod Brown (D-OH) and Ted Kaufman (D-DE), will soon introduce legislation that would impose strict size limits on financial firms.  The legislation would limit bank holding companies’ insured deposits to no more than 10% of the nation’s total deposits, and non-deposit liabilities to 2% of GDP.  Banking companies that currently exceed those size limits – including JPMorgan Chase, Wells Fargo, and Bank of America – would have three years to downsize.

“This is what it takes to make sure we never have to revisit ‘too-big-to-fail,’” Senator Kaufman said.

The proposed legislation is misguided – the wrong response to the wrong problem.  The problem of “too-big-to-fail” is not that some institutions are large; the problem is that there is currently no statutory authority to wind down a failing financial conglomerate in the way that the FDIC is currently authorized to wind down a bank.  More effective supervision, coupled with the authority to seize and wind down large firms, is the appropriate remedy to “too-big-to-fail.”

 

Large Institutions Are Not Inherently More Risky

• The fundamental error of efforts to arbitrarily break up large institutions is the presumption that being large is somehow bad or inherently more risky.  This presumption is false.

• Large institutions are far more diversified in their business mix as compared to smaller institutions, which tend to be engaged in fewer businesses and regions and, therefore, are exposed to greater concentration risk.  In this regard, larger institutions are more stable than smaller institutions.  Rather than being a source of risk, size can be a risk mitigant.

• 197 banks have failed since January 2009 – 140 in 2009, 57 so far this year.  189 of those failed banks had assets of less than $5 billion, and 160 had assets of less than $1 billion.

 

Large Financial Institutions Provide Significant Value to Customers and Markets

• Because of the efficiencies of scope and scale, larger firms are more efficient.  Last October, University of California economist Oliver Williamson won the Nobel Prize for economics for his groundbreaking work on the “boundaries of the firm,” and specifically for demonstrating that it can be more efficient to extend the size and scope of activities of a single firm than for a number of smaller firms to contract independently.

• Research conducted by Charles Calomiris, Columbia University finance professor, shows that the gains produced by efficiencies of scale and scope accrue to customers in the form of better and cheaper financial services.

• Large financial institutions – active in many markets and many countries across the globe – have served to integrate global stock, bond, and foreign exchange markets, making those markets more modern, liquid, and efficient.

• Large, globally active financial institutions have expanded the supply of credit and other financial services to emerging market economies, contributing importantly to the expansion of trade flows, opening foreign markets to U.S. goods and services and, therefore, contributing importantly to economic growth and job creation.

 

Large Financial Institutions Contribute to U.S. Competitiveness

• Because large diversified financial institutions provide significant economic value that clients and customers rely on, the likely effect of any attempt to arbitrarily and preemptively break them up would be that large firms would leave the United States – taking their economic value, expertise, and jobs with them to other countries.

• To be a global financial leader, the United States needs small, medium and large financial institutions, with various business models, and areas of expertise.  Being a global financial leader is an enormous strategic advantage for the U.S. economy and American businesses, workers, savers, and investors – an advantage we should work hard to preserve.

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