Wednesday, August 22, 2012

Breaking Up The Banks Is No Free Lunch (Nor Even A Very Nutritious One)

Paul Mirengoff at Power Line has offered a qualified endorsement of the call by some conservatives such as Paul Rahe, Erick Erickson and others to break up the big banks.

I write this blog under a pseudonym in order to express political views without risking professional repercussions, so I want to be careful about what I say and how I say it. But I will say that this is a topic about which I am alleged to have some measure of professional expertise, or at least experience. So I will offer some observations about this ongoing debate. This will necessarily be an abbreviated analysis, but I welcome feedback and will be happy to expand upon or clarify parts of this upon request.

I am no great fan of universal banks; it has been clear to me since well before the Citicorp - Travelers transaction in 1998 that this structure, and indeed vast scale regardless of scope, tends to reward senior executives while inflicting inferior returns on shareholders. That we have such institutions at all is due less to free market forces than to the thwarting of free market forces by friction in our corporate governance structures. The transactions that built these institutions were generally very painful indeed for shareholders.

I am also shocked that neither President Obama nor Governor Romney has advocated creaking up the big banks. All merits aside, the idea seems to have great populist appeal on both the right and the left, and would thus seem to be pretty low hanging fruit for candidates fighting for whatever marginal edge they can get.

So breaking up the big banks may make political sense. And it may well prove shareholder-friendly, which implies at least some economic benefits.

But we should be deeply, deeply skeptical of claims that breaking up the banks would meaningfully reduce the risk of either financial catastrophe or of related pressure for future bailouts.


First, we need to decide what we mean by "breaking up" the banks. Are we talking about breaking them up by line of business (i.e. the common understanding of Glass-Steagall which hived off investment banking from commercial banking), or by geography (so a Bank of America's coast-to-coast branch network gets broken back up into some number of regional commercial banks), or some combination thereof?

Let's take the Glass-Steagall scenario first since it seems to get the most attention.

If we seek to rebuild the Chinese Wall between investment and commercial banking, it would have many effects, but ending Too Big to Fail would not be among them. Splitting up Bank of America and Merrill Lynch would simply turn one TBTF institution into two TBTF institutions.It would also needlessly sever other relationships; anyone suggesting that Scott and Stringfellow somehow makes BB&T Financial more likely to get into trouble needs his head examined. Conversely, US Bancorp sailed through the financial crisis with comparative ease for a number of reasons, but its' earlier disposition of Piper Jaffray is not really one of them.

Nor is it clear that it would meaningfully reduce systemic risk. Think back to 2008; the fundamental problem was with the risk embedded in the assets Bank of America and Merrill Lynch held, not with the legal structure in which the assets were domiciled. And those problems existed at pure investment banks or pure commercial banks every bit as much as at universal banks. For every Citigroup (that might well have failed absent government support), there were multiple Bear Stearns or Washington Mutuals that failed, to say nothing of non-banks such as AIG.

Indeed, having such a Chinese Wall in place during the financial crisis could very easily have increased the costs to taxpayers. What would have happened in early 2007 if JP Morgan Chase had been barred from acquiring the carcass of Bear Stearns? Would the crisis have passed so quickly if Bank of America had been precluded from acquiring Merrill Lynch? There are good reasons to believe that both transactions at least marginally muted the severity of the crisis.

What if, instead of a Glass-Steagall strategy, we pursue a Baby Bell strategy and break up the big banks into some number of smaller, regional institutions?

The particulars are different, but in the end, you are mostly just moving risk around rather than reducing it, and replacing "too big to fail" with "too many to fail."

Let's say we broke up Bank of America into a Northeastern bank (we'll call it "Fleet Financial"), a Southeastern bank (we'll call it "NCNB"), a Midwestern Bank (We'll call it "Boatmens Bancshares"), a Southwestern bank (we'll call it "First Republic Bank of Texas"), and a West Coast bank (we'll call it "BankAmerica Corp").

Individually, none of those five might be considered too big to fail. And in a purely region- or sector-specific crisis, it is entirely possible that only one would fail while the others held up - for example, First Republic of Texas might fall prey to an energy sector collapse while the others were relatively unscathed. That's what happened in 1986 after all.

In a widespread crisis, however, we would likely find that the various regional banks were all highly correlated. For example, the current iteration of Bank of America is large enough to hold on its balance sheet loans to giant customers that smaller regionals could not. In a world without the too big to fail banks, giant companies still need to borrow from somebody. An Atlanta multinational still gets its loan from, say, NCNB, but then NCNB syndicates the loan out to the other four Baby BofAs. Net risk reduction versus the TBTF structure: zero.

Regulatory capture may have been made marginally easier as bank balance sheets have increased in size, but you don't have to go back very far to realize that in the absence of American universal banks, smaller institutions like Chemical Banking, or First Chicago, or Salomon Brothers - to say nothing of much smaller institutions such as Dillon Read - never lacked clout in Washington. There were never any "good old days before regulatory capture."

Capital levels are a different debate, with a different trade-off. Higher equity levels trade reduced risk of failure for reduced availability of credit. We should strive to identify the optimal trade-off, but we should be under no illusion about the trade-off's existence.

In financial structure, as in every other facet of life, there is no such thing as a free lunch. 



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