The Role of Finance in the Economy: Implications for Structural Reform of the Financial Sector

Executive Summary
The U.S. financial system is critical to the functioning of the economy as a whole and banks are central to the financial system. In addition to providing substantial employment, finance serves three main purposes:

Credit provision. Credit fuels economic activity by allowing businesses to invest beyond their cash on hand, households to purchase homes without saving the entire cost in advance, and governments to smooth out their spending by mitigating the cyclical pattern of tax revenues and to invest in infrastructure projects. Banks directly provide a substantial amount of credit in the U.S., but, unlike in almost any other economy, financial markets are the ultimate providers of most credit.

Liquidity provision. Businesses and households need to have protection against unexpected needs for cash. Banks are the main direct providers of liquidity, both through offering demand deposits that can be withdrawn any time and by offering lines of credit. Further, banks and their affiliates are at the core of the financial markets, offering to buy and sell securities and related products at need, in large volumes, with relatively modest transaction costs. This latter role is particularly important in the U.S., given the dominance of markets, but is often under-appreciated.

Risk management services. Finance allows businesses and households to pool their risks from exposures to financial market and commodity price risks. Much of this is provided by banks through derivatives transactions. These have gotten a bad name due to excesses in the run-up to the financial crisis but the core derivatives activities provide valuable risk management services.

Many argue that the U.S. financial system grew overly large in the bubble period and is still too large today. We agree that some of the activities that took place in the bubble period involved taking on excess amounts of risk, but it is extremely hard to determine the right size of the financial system based on well-grounded economic theories. In truth, it is very difficult to judge the right size of almost any industry and attempts at the use of central planning and other mechanisms to correct assumed problems of this nature have usually failed.

Nonetheless, it is reasonable to assume that a sector will be too large if there are unwarranted economic subsidies flowing to it. This does appear to have been the case in the bubble and may still be the case, although such subsidies have been much reduced by a series of actions to remove government support and to force the financial industry to operate more safely.

However, we suspect the excessive size in the bubble period was considerably less than many argue and we believe it is important to be cautious in drawing policy conclusions as it seems impossible to prove whether the sector was or is too large and by how much.

There are a number of important proposals to force major changes in the structure of the financial industry, including to:

  • Eliminate Too Big to Fail banks by forcing their break-up or downsizing
  • Limit the functions of banks à la Glass Steagall or the Volcker Rule

Banks that are central to our financial system, whether through sheer size or the critical nature of the services they provide, are perceived by many to benefit from an implicit government guarantee that ought to be eliminated. The main categories of proposals are:

  • Break up the largest banks
  • Mandate a size limit
  • Push large banks to shrink voluntarily by imposing stiff costs for size
  • Put in place a credible plan for resolving the largest institutions

We do not favor the proposals to break up the banks or force them to shrink dramatically. We believe that the best analysis indicates considerable economic benefits to size and scope and that these advantages are likely to grow further with increasing globalization, complexity, and improved information and management systems. America should have at least a few financial institutions with global scale, capable of providing a wide range of related commercial and investment banking services, operating on a scale in individual product lines that produces real efficiency.

This will almost certainly mean these firms are important enough to the economy that the government and regulators will need to watch them particularly carefully and may create need for special assistance, in extreme crisis situations of the level that are unlikely to occur more than once or twice a century. For this reason, we agree on the need to designate systemically important financial institutions and to require them to operate with higher safety margins.

We believe that the societal benefits of breaking up the large banks are over-stated. The recent financial crisis was much more about system-wide problems than about issues resulting from excessive size of financial institutions. A simple thought experiment illustrates this. If we had broken up the big banks a decade ago into 10 or 20 pieces each, they would likely all or virtually all have made the same mistakes. They would have over-invested in real estate-related products, taken excessive risks across the board, created opaque and risky securitizations and derivatives products, pushed accounting rules to their limits, etc. The other players in the financial system would presumably also have made the same mistakes, including the ratings agencies, governments, central banks, regulators, and families and businesses. It is difficult to presume that the disaster would have been much different. Indeed, there is a chance that the clean-up would have been more difficult without the ability to pull 17 key CEOs into a room and force them to accept the TARP arrangements.

The next financial crisis will almost certainly differ from the last, as every such crisis varies, but it remains difficult to see how a system of many mid-sized banks would be appreciably safer than one with some large banks as part of the mix.

We do favor ensuring that even the most important banks can be resolved effectively without the use of taxpayer funds, except perhaps for relatively short-term liquidity purposes and backed by solid collateral. Dodd-Frank goes a long way towards achieving this goal, but more could be done.

Activity limitations

U.S. commercial banks and their affiliates have always faced limitations on the business they are allowed to undertake, in order to reduce the risk of business disasters that would endanger their ability to fulfill their critical role at the heart of the economic system.

These limitations were considerably extended in the Great Depression. The Glass-Steagall Act was passed, making it illegal for a commercial bank to be affiliated with an investment bank. The former could undertake the types of activities we normally associate with banking, such as taking deposits and lending. The latter were principally involved in the securities business, through helping firms raise capital by selling stocks and bonds, assisting investors in buying and selling those securities, and trading them for the investment bank’s own account.

The anti-affiliation provisions of Glass-Steagall were dramatically modified in the 1990’s, allowing commercial and investment banks to be part of the same financial group, although there remain a number of important restrictions to limit dealings within the group.

There is a range of proposals to further limit the ability of banks to operate in the securities and derivatives businesses. Some call for a restoration of the anti-affiliation provisions of Glass-Steagall. Others want Glass-Steagall Lite, since they recognize that changing times make it difficult to simply turn back the clock. The Volcker Rule is intended to separate out proprietary trading completely from commercial banks and investment banks.

We do not favor any of the major proposals for further structural divisions between commercial banking and securities and derivatives activities. We believe that the U.S. capital markets are world leaders and that their strength is an important economic advantage for America. Those markets are underpinned by the role of major securities dealers that are closely affiliated with commercial banks. A major reason for the close linkages is the desire of corporate customers to be able to deal with financial firms that can provide a solid range of products from financial advice to loans to securities offerings to risk management via derivatives to purely operational products. The institutional knowledge and relationships that a banking group has in regard to its corporate customers is a valuable advantage both for the bank and for those customers. 

Further, times have changed and will not change back. Glass-Steagall was based on a clear difference between a loan and a security, a difference that no longer exists now that most large loans are tradable among banks and also specialized investors. At this point, it is usually possible to structure a given transaction as a loan or a security or a derivatives transaction or often as insurance or another contractual arrangement.

Finally, any transition from the current system to an older-style system will create very considerable displacement of activities, with a real potential for problems. Some of this might occur through the divestiture of investment banking subsidiaries from banking groups, which would be the simplest approach; however even this would involve a large amount of change at a time when the U.S. economy remains in a fragile recovery that resulted in part from the disruption of the financial sector.   Another source of displacement would result from striving mid-level securities firms grabbing market share. Although this could bring advantages, it also creates the danger of a repeat of a situation such as developed at MF Global, where the push for growth overcame proper risk management practices.