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If the Fed Knows Banks Are Too Big, Why Doesn’t It Make Them Smaller?

James Kwak challenges the

The Federal Reserve is serious—about something.

On May 2, The Wall Street Journal reported that regulators were pushing to require “very large banks to hold higher levels of capital,” including minimum levels of unsecured long-term debt, as part of an effort “to force banks to shrink voluntarily by making it expensive and onerous to be big and complex.” The article quoted Fed Governor Jeremy Stein, who said, “If after some time it hasnot delivered much of a change in the size and complexity of the largest of banks, one might conclude that the implicit tax was too small, and should be ratcheted up” (emphasis added).

A few days later, Fed Governor Daniel Tarullo said roughly the same thing (emphasis added):

“‘The important question is not whether capital requirements for large banking firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them so,’ said Mr. Tarullo, adding later that even with those measures in place it ‘would leave more too-big-to-fail risk than I think is prudent.‘”

Tarullo recommended higher capital requirements and long-term debt requirements for systemically risky financial institutions.

Last week, Governor of Governors Ben Bernanke quoted from the same talking points (emphasis added):

“Mr. Bernanke said the Fed could push banks to maintain a higher leverage ratio, hold certain types of debt favored by regulators, or other steps to give the largest firms a ‘strong incentive to reduce their size, complexity, interconnectedness.’

“The Fed chairman acknowledged growing concerns that some financial companies remain so big and complex the government would have to step in to prevent their collapseand said more needs to be done to eliminate that risk.”

It’s important to note exactly what Stein, Tarullo, and Bernanke are all saying.

  • Here’s what they’re not saying: Too-big-to-fail banks enjoy implicit subsidies and impose externalities on the rest of us; therefore those subsidies and externalities should be priced; and then those banks can decide whether they want to absorb those costs or make themselves smaller.
  • Here’s what they are saying: Too-big-to-fail banks are too big and complex and pose a systemic risk to all of us; therefore they need to become smaller and less complex; and the Fed will tweak the regulations until they become smaller and less complex.

What’s remarkable about this? These three men—probably the three most important on the Board of Governors when it comes to systemic risk regulation (as opposed to monetary policy, for example)—all say that they know that the megabanks are too big and complex. They all say that accurate pricing of subsidies and externalities is not an end in itself.* They all say that the goal is smaller, less complex banks.

But here’s what baffles me: If the goal is smaller, less complex banks, why not just mandate smaller, less complex banks? Why beat around the bush with capital requirements and minimum long-term debt levels? Those tools might be appropriate if you think huge, complex banks should exist but you want to make them safer. But if you’ve already concluded that banks need to be smaller and less complex, then they’re just a waste of time.

They also betray a frightening naivete regarding corporate governance. The theory is that higher capital requirements, for example, will lower banks’ profits, which will upset shareholders, who will eventually force the board of directors to eventually convince the CEO to break up his empire. This scenario, unfortunately, depends on the premise that American corporations are run for the benefit of their shareholders, which is only roughly true, and even that often requires long, expensive, and messy shareholder activist campaigns.

Instead, there’s an obvious solution: rules that limit the size and scope of financial institutions. But Bernanke has ruled out “arbitrary” size caps in favor of his cute regulatory dial-tweaking.

Again, Bernanke’s position might be defensible if he wasn’t already sure that today’s banks are too big and complex. Then it might make sense to tweak the incentives and see how the market reacts. But if he knows they are too big and complex, he should eliminate that risk in the simplest, most direct way possible. If he’s not sure how much smaller and simpler banks need to be, he can do it in steps: set one set of size and scope limits, see what he thinks about the outcome, and then set another set of limits if he’s still unhappy.

To use a crude analogy, let’s say we’re concerned about guns on airplanes. Ben Bernanke thinks, like I do, that guns on planes present an unacceptable risk to the safety of air travel. But his approach is to charge a $100 fee for anyone who wants to bring a gun onto a plane. If people keep bringing guns on board, he’ll raise the fee to $200, then $300, and so on until people stop. The sensible, obvious solution is to just ban guns on planes. But that would be “arbitrary.”

* It is theoretically plausible that one should simply price the subsidies and externalities and then let the market determine whether big banks provide enough societal benefit to offset the costs they impose on the rest of us. But that is not what Stein, Tarullo, and Bernanke are saying.