Break Up the Banks

The biggest banks in the United States have become too big – from a social perspective.  There are obviously private benefits to running banks with between $1 trillion and $2.5 trillion in total assets (as reflected in today’s earnings report), but there are three major social costs that the case of Goldman Sachs now makes quite clear.

1)      The megabanks have little incentive to behave well, in terms of obeying the law.  There is fraud at the heart of Wall Street, but these banks have deep pockets and suing them is a daunting task – as the SEC is about to find out.  The complexity of their transactions serves as an effective shield; good luck explaining to a jury exactly how fraud was perpetrated.  These banks have powerful friends in high places – including President Obama who still apparently thinks Lloyd Blankfein is a “savvy businessman”; and Treasury Secretary Geithner, who is ever deferential.

2)      The people who run big banks brutally crush regular people and their families on a routine basis.  You can see this in two dimensions

A. They are not inclined to treat their customers properly.  They have market power in particular segments (e.g., new issues or specific over-the-counter derivatives) and there are significant barriers to entry, so while behaving badly undermines the value of the franchise, it does not destroy the business.  Talk to some Goldman customers (off-the-record; they don’t want to bite the hand that hurts them).  Lloyd Blankfein still claims that the client comes first for Goldman; most of their clients are surprised to hear that.

B. Small investors also lose out.  Who do you think really bears the losses when John Paulson is allowed to (secretly, according to the SEC) design securities that will fail – and then pockets the gains?

3)      Underpinning all this power is the ultimate threat: Too Big To Fail.  If a big bank is pushed too hard, its failure can bring down the financial system.  This usually means protection when the system looks shaky, but it can also protect big banks from serious prosecution – if their defenders, like Jamie Dimon, can make the case that this would undermine system stability and slow the creation fo credit.  (This is startlingly parallel to the arguments made by Nicolas Biddle against Andrew Jackson during the 1830s; see chapter 1 of 13 Bankers).

In turn, this puts competitors at a major disadvantage, because the bigger banks can borrow on better terms.  The extent of protection provided to management and boards in 2008-09 was excessive, but what really matters is the protection perceived and expected by creditors going forward.  And this is all about whether you can credibly threaten the creditors with losses.  This, in turn, is about a simple calculus – if a firm is in trouble, will it be saved?

There are simply no social benefits to having banks with over $100 billion in total assets.  Think clearly about this – and if you dispute this point, read 13 Bankers; it was written for you.


Originally published at The Baseline Scenario and reproduced here with the author’s permission. 

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One Response to "Break Up the Banks"

  1. Guest   April 21, 2010 at 2:48 am

    Well presented point of view but I do not see the political system moving in this direction and making any policy changes. A regulatory scheme that empowers the executive branch to liquidate institutions seems to me a reinforcement of the corporatist model in the US that has led to rampant Beltway crony capitalism.Simon ought to propose some specific legislative measures that would make effective policy change. In my mind, it would mean changing the tax code and regulatory rules to punish concentration and encourage more diversity in financial firms. Another tact would be antitrust rules and actions against excessive financial concentration.As it stands now, the system is a symbiotic relationship. Politicans by concentrating their regulatory power extract protection money from large institutions in the form of political donations. Government concentration of power goes hand in hand with corporate concentration of power. There is as much government misfeasance as corporate misfeasance. Moral hazard increases rather than decreases.