Too Big to Fail or Too Many to Fail: Would Breaking Up Big Banks Work?

Source: Thinkstock

Source: Thinkstock

During the financial crisis, policymakers in the U.S. were faced with an incredibly difficult decision: either bailout the nation’s largest financial institutions or let them fail. If they chose the first option, they were effectively submitting to the toxic effects of moral hazard; if they chose the second option, they risked allowing the economy to slip into full-blown depression.

To make a long and complicated story short, they chose the first option. Policymakers in Congress and at the Federal Reserve committed to rescuing “too big to fail” financial institutions like AIG (NYSE:AIG), Citigroup (NYSE:C), and Bank of America (NYSE:BAC), whose failure threatened systemic economic breakdown. These institutions were either responsible for originating bad loans and packaging them into toxic securities, or recklessly insured these products and were unable to meet obligations when the shit hit the fan.

The total cost of bailout packages extended to financial institutions during the crisis was enormous, and taxpayers shouldered it. According to the bailout tracker maintained by ProPublica, policymakers put $611 billion on Main Street’s tab: $45 billion went to Bank of America, another $45 billion to Citigroup, and $67.8 billion went to AIG, along with other federal aid including an $85 billion credit line from the Fed.

Many people viewed these bailouts as atrocious, and in the wake of the crisis the issue of financial reform had at its core a crucial debate about how to handle banks that were too big to fail.

Paul Volcker, the former chief of Federal Reserve who is credited with saving the U.S economy from high inflation and high unemployment in the 70s, has been a leading advocate of one particular strategy: just break TBTF banks up. Once TBTF banks are broken up, a regulatory framework could be adopted that would prevent any financial institution from becoming that large again, effectively solving many of the problems that led to the financial crisis and riding the markets of moral hazard.

While this idea seems like a natural fix, Volcker has his opponents. Economists like Stanley Fischer, vice president of the Fed Board of Governors, and Paul Krugman, a Nobel laureate, believe that simply breaking up TBTF banks is too complex a task to be feasible and that even if it were possible, the payoffs are uncertain.

“What about simply breaking up the largest financial institutions?” Fischer asked in a speech he gave at the National Bureau of Economic Research in Cambridge on July 10; later, he asked, “Would breaking up the largest banks end the need for future bailouts?”

The answer here “is not clear.” The correct course of action depends on the answers to some big questions about the organization of the financial sector at large that we just don’t have information or insight to produce yet. The operative question, as Fischer put it, is, “Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms?”

The answer depends on understanding the nature of financing premiums for large firms, and that’s something we don’t fully understand.

The alternative to breaking up bigger banks lies in tightening and updating financial regulation. This means more capital control, increased capital and liquidity ratios for banks irrespective of risk weights, curbs on shadow banking, periodic stress tests, and effective implementation of Dodd-Frank Act regulations that may ensure that bank failures are resolved without having the taxpayer bear the cost.

According to Nobel Prize winning economist Paul Krugman, “Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn’t be concentrated on a few big companies — but it would be a bailout all the same.”

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