The British magazine Prospect has one of the better explainers on too big to fail I’ve yet seen. It’s a very good overview of the problem—a one-stop shop if you still haven’t figured out why we’re always calling on the press to emphasize it.
It starts with an excellent lede recalling analyst Dick Bove’s “buy” recommendation of Citigroup several months ago—a call made despite its loan portfolio being “one of the poorest ever written.” But Uncle Sam had backstopped it, so it had more upside potential than downside. Heard that phrase “socialize the losses, but privatize the gains”? There you go.
And it lists some of the stunning growth of banks over the last decade:
As recently as 1999, Royal Bank of Scotland had assets of just £89bn. By the time it was rescued last autumn, its balance sheet—boosted by the takeover of Dutch bank ABN Amro a year earlier—had swelled to almost £2.4 trillion.
RBS is now 84 percent owned by the government.
Jonathan Ford and Peter Thal Larsen do a good job of debunking the excuses for TBTF:
Why did the banks expand so fast? Apologists have advanced two possible explanations. One is that the globalisation of capital flows has created the need for large financial institutions that can operate around the world. The second is that very large banks are more efficient.
The first is difficult to accept. If you spool back ten years, Goldman Sachs was considered to be a strong global bank. Its balance sheet is now almost five times bigger. It is simply hard to believe that the ideal size for a global bank should have risen so sharply in a single decade.
The efficiency case is also weak. Much of the academic evidence contradicts the idea that size itself makes a bank more efficient. A 2002 report for the US Federal Reserve looked at banking mergers in the US, Europe and Japan and concluded that scale provided advantages only up to a low level of total balance sheet assets (about $50bn). Beyond that there were disadvantages in greater size arising from the complexity of running such large organisations—especially multinationals.
Companies would prefer to have more, smaller banks so that they can spread their business to ensure they get the best deal. Most large commercial or investment banking transactions, after all, involve a syndicate or group of banks to divide up the risk.
So why do the masters of the universe care so deeply about scale? For one, masters tend to prefer big universes rather than small. But, of course, it’s a pay thing:
But while bigger banks add little for the customer or shareholder, they have proved lucrative for top executives. Individual bankers have had an overwhelming incentive to pursue size for its own sake.
Prospect doesn’t go into it, but if you’ve got fewer companies in an industry, those at the top will get paid more. It’s pretty simple.
It’s when Ford and Thal Larsen get to the possible fixes that they run into a little trouble. They dismiss out of hand “arbitrarily setting caps on the size of banks.” But who’s suggesting that? Surely there’s a way to study what might be an optimal limit on concentration rather than just pulling a number out of a hat.
And they dismiss reinstating the Glass-Steagall separation of trading from traditional deposit banking as not making the system safer (although there’s plenty of room to disagree with that), since it would still allow for giant investment banks like Goldman Sachs and Morgan Stanley. Well, it’s not like Glass-Steagall II would have to be the limit of any new regulation. It could, of course, be combined with those limits on size and leverage for all financial institutions—whether Goldman, Citigroup, Bank of America, PIMCO, or Citadel.
Here’s what Ford and Thal Larsen recommend:
Restoring Glass-Steagall may be a step too far, but banks should be forced to separate risky activities and fund them without recourse to the guaranteed parts of the institution.
What’s the difference—if that was really a sturdy firewall? Does anybody believe it would be?
And would raising capital requirements really be a way to rein in Giganto banks? The European banks themselves were the prime examples of how capital requirements aren’t exactly airtight. PBasically, They bought credit insurance from AIG that enabled them to account for higher capital reserves than they actually had, since the credit risk had supposedly been offloaded to AIG. Haven’t heard of regulatory capital arbitrage (and who doesn’t love digging into the arcana of such things)? Joe Nocera had a nice column explaining it a few months ago in The New York Times. Policing such things would require smart regulators, a fix the authors rightly question earlier in the piece.