Proposals for radical restructuring of the banking sector have surged again, fueled by the recent wave of banking scandals. These scandals add to the public's justified anger at the contributions of bankers to the financial crisis and its extremely damaging aftermath. They also magnify a sense among many that the big banks are both too powerful and too big to manage well. However, anger and frustration have been very poor policy guides for dealing with the financial system and I firmly believe that many of the proposals to restructure banking would damage all of us.
Lest this sound like the pleadings of an ex-banker, which I am, let me emphasize my prior strong and vocal support for financial reform. This includes the two major reform packages: the Dodd-Frank Act and the Basel III accord, the international agreement requiring major increases in bank safety margins. These reform packages are by no means perfect, but their overall approaches are necessary and valuable. However, regulation is always about the balancing of costs and benefits. We could have an extremely safe financial system that provided insufficient fuel for the dynamic economic growth that we need, just as we could have extremely safe cars that cannot go more than 50 miles an hour and cost twice as much as they do now. We should not lose sight of the real economic advantages to having at least a few large U.S. banks that can efficiently provide a full range of services and products globally.
There are a series of proposals to force major changes in the structure of the banking industry, with the intent of either forcing the largest banks to be much smaller or requiring the separation of their deposit-taking and lending activities from their securities market activities. These include:
- Proposals to "restore Glass-Steagall", although these are often quite vague
- Thomas Hoenig's idea of forcing most securities activities out of commercial banking groups
- The Volcker Rule, especially in harsher forms
- Use of Single Counterparty Credit Limits in relatively extreme form to impose a major pullback in securities and derivatives activities by the largest banks
- Use of "Living Wills" to force a sharp simplification of corporate structures
- Outright break-up of the largest banks
- The Vickers Commission approach in the UK of firewalls and increased capital
- The Liikanen panel's study of structural approaches to financial reform in Europe
These proposals generally share the underlying assumptions that banks are much bigger and more diverse than they should be and that securities activities are not closely related to the core of what banks ought to be doing.
There are three major problems with these assumptions. First, the many other reforms being put in place render such dramatic changes unnecessary. Second, radical restructuring would sacrifice the substantial benefits these banks provide to economic growth. Third, dramatic structural changes would create serious risks, both in the transitional period and in the longer run.
Dodd-Frank and Basel III already mandate comprehensive increases in bank safety. A partial list of important provisions includes:
- Enhanced capital requirements for all banks
- Capital surcharges on systemically significant institutions
- New liquidity requirements for all banks
- New approaches to resolving the problems when banks get into trouble
- Annual Fed-run stress tests for all significant institutions
- Living wills for all significant institutions, updated annually
- Movement of derivatives trading onto exchanges
- Rules restricting proprietary trading (the Volcker rule)
- The creation of the Consumer Financial Protection Bureau
- Enhanced regulation by the Securities and Exchange Commission and the Commodity Futures Trading Commission
- The creation of the Financial Stability Oversight Council to oversee regulation
- Enhanced reporting requirements for credit risk and other measures
Adding radical structural change on top of all this is both unnecessary and potentially quite harmful. In particular, there are real economic advantages to having banks that can provide our businesses with a wide range of services, in many different countries, with large enough volumes to minimize costs. There are also many benefits to combining: the direct provision of credit via bank loans; the indirect provision of credit through management of securities offerings in financial markets; market-making activities to keep financial markets liquid; and the offering of risk management tools, including derivatives. Forcing banks to choose which set of services to provide, or to operate at an inefficient scale, would push up the cost of credit and reduce its availability. Our economy is already struggling, in part due to poor credit conditions. Ensuring that burden lasts even longer is not desirable.
Finally, these restructuring proposals represent major, risky experiments. The probability of serious unintended problems is high and the transitional period would be especially fraught with peril. For example, there would be a dramatic shift of business towards financial firms that do not have much experience with the more sophisticated and trickier parts of finance. Unfortunately, there is a long history of medium-sized financial firms blowing up when they expand too rapidly into complex areas, with MF Global as a recent example. It is highly likely that such problems would recur.
It is true that there are risks and problems with a system that includes large banks. However, debate on financial reform often takes as a given that there are only problems and costs, whereas the economic benefits are actually substantial. It is difficult to quantify, but I am confident that the economic benefits of these firms will outweigh their costs in the future under the new regulatory regime. At a minimum, we should certainly be very careful to balance both costs and benefits when considering any of these restructuring proposals.
In that regard, it is worth emphasizing that no one has convincingly shown that breaking up the banks would have had a major effect on the financial crisis. Excessive risk-taking, too little bank capital, too little bank liquidity, a housing bubble, government policy that encouraged risk, very low interest rates, general over-optimism, compensation structures that encouraged excessive risk taking, and other underlying factors would have fueled an equally damaging crisis even if none of the banks had been as large.