If the Fed can't rein in big banks, breaking them up won't work either

A short introduction to the latest on too-big-to-fail

This article appeared first on Canadian Business

Five years after the financial crisis America’s big banks—the ones that survived—are even bigger (and so, incidentally, are Canada’s). President Obama’s gargantuan Wall Street overhaul bill, known as Dodd-Frank, became law in 2010 and myriad federal agencies have since been feverishly at work to write up the regulation needed for implementation. That includes the Federal Reserve, which is fine-tuning a set of new rules that are supposed to tackle the too-big-to-fail problem in America’s banking system.

This has sparked a spirited discussion among normally mild-mannered economists on how exactly one should go about doing that. I’ve been listening to Fed officials’ speeches and testimonies and reading their critics’ op-eds in various papers and blogs for so long that the debate now plays out like an interior dialogue in my head. It goes like this:

FED AND SUPPORTERS OF THE FED’S APPROACH: We do not want to break the banks. Instead, we’re going to force very large banks to hold higher levels of capital and take on less risk, making sure that they remain safe and sound.

FED CRITICS: But the banks are too big.

FED: They totally are. But if we force them to hold more capital and take less risks they either become safe or won’t be able to achieve the economic returns needed to justify their size and will have to break themselves up.

FED CRITICS: They will not break themselves up. What? Do you expect shareholders to force them to cut themselves up? Seen how things played out with Jamie Dimon after the London Whale affair, good luck with that. Shareholders are powerless. If we agree the banks are too big, why not just break them up ourselves?

FED: Because we’ve tried that before, when we separated commercial banks and investment banks with the Glass-Steagall act of 1933. And then they both separately got into horrible trouble during the financial crisis.

FED CRITICS: But the problem is even worse after the financial crisis. Now everyone knows and expects that the government will bail out the big banks, which makes them essentially invincible. They will be able to borrow cheaply because investors, who trust the government will get them out of trouble, will demand low returns for lending them the money. And by borrowing cheaply they will be able to accumulate enormous amounts of risk, becoming an even worse threat to financial stability than they were.

FED: We are aware of that unfair advantage that’s been baked into the system by the various bailouts. What we’re trying to do with our new rules is increase the costs that banks face for being too big—so that it isn’t a free lunch anymore.

FED CRITICS: But the new regulations you’re working on aren’t strict enough. They won’t do anything.

FED: We’re not positive what’s in the works now will be enough. If it isn’t, we’ll add more.

FED CRITICS: No, your regulations won’t be enough because you either don’t understand how big banks work or you’re too cozy and/or too scared of them to be serious about fixing the too-big-to-fail problem.

This is where my mental marionette show ends, and I always come up with the same question: If the Fed is unable or unwilling to do tackle too-big-to-fail, why would a re-enactment of Glass-Steagall work? Sure, it sounds straight forward: pick a metric for measuring size, define how big too-big is, and enforce. You can split the banks by function or by asset type. But what would prevent the banks from circumventing those regulatory boundaries too if they rules were purposefully weak, or just not good enough. The lines between banks, insurance companies and hedge funds seem blurry enough nowadays to leave amble room for creative interpretation. The same holds for efforts to limit banks’ size by asset or activity. Just take a look at the Volcker Rule, a section of Dodd Frank, that would impose strict restrictions on what banks with retail customers and access to government-backed deposit insurance can do when they gamble with their own money rather than trade on their clients’ behalf. The rule hasn’t been implemented yet and Goldman Sachs has allegedly already found ways around some of its strictures.

I’m not arguing that the Fed necessarily knows what it’s doing or that it is acting in good faith. But if there is a major problem at the Fed about regulatory competence or so-called regulatory capture, where banks can influence the Fed to lessen the weight of regulation, then any effort to end too-big-to-fail seems doomed, regardless of which regulatory approach one might pick.

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