What Should be Done About Bank Size?

Although there is a great deal of debate over whether plans to reform the United States’ financial regulation system go far enough to curb institutions that become “too big to fail,” it is not a good idea to try and limit the size of US banks or other financial institutions, which are in many cases smaller than foreign owned banks. Size limits would encourage the industry to move offshore and would probably encourage institutions to make their portfolios more risky – if they have to cut out some of their assets they will cut out the ones making lower returns. New York is a financial hub for the world economy and needs large banks to sustain its position. Financial services have been one of our most successful export industries and we should not impose restrictions that make the US industry uncompetitive.

There is no perfect answer to “too big to fail” but the two most promising approaches are as follows:  First, create a resolution authority (or a special bankruptcy court) so that large banks can be closed down in an orderly fashion without excessive disruption to the system as a whole. The most difficult part of this approach is resolving international banks and that requires cooperation with other countries, especially other financial hubs such as London. The resolution process should heavily penalize managers and shareholders and make bond holders take losses. A special fund should be available to make sure the institution is kept operating until it can be sold off or shut down. This fund should be drawn from a levy on other financial institutions, especially other large financial institutions.

The second approach is that financial institutions should be required to hold more capital the bigger and riskier they get. The approach should not be punitive but should capture the additional risks imposed by large and complex institutions on the financial system as a whole. Large banks should also be subject to additional scrutiny from regulators to make sure they are following sound risk management strategies.

The two biggest problems in the financial crisis were, first, that financial institutions did not have adequate risk management rules or did not follow them if they had them. Second, regulators pored over the books of the banks but never really tested whether they were keeping their risks under control. These problems were not specifically problems of size, but of poor management and regulatory practices and these must be changed going forward.