Break Up the Banks

The Too Big to Fail Problem Can't be Ignored

Too big to fail (TBTF) banks were key to causing the financial crisis and spreading the contagion around the globe. Yet what has happened to the biggest banks in America? You guessed it – they have gotten bigger. After absorbing Merrill Lynch, Bank of America is now the largest bank in the United States. After gobbling up Washington Mutual and Bear Sterns, JP Morgan Bank is second. Wells Fargo took over Wachovia and the zombie bank Citi (theoretically) rounds out the top four.

According to Nobel prize winning economist Joseph Stigliz: “In the U.S. and many other countries, the too-big-to-fail banks have become even bigger. The problems are worse than they were in 2007 before the crisis.”

Size Matters 

No company should be permitted to get big enough to imperil the financial system. No company should be permitted to get “interconnected” enough to crash the global economy. And the bigger the company, the more concentrated the political power; the more lobbyists the firm can field; the more campaign cash their employees can provide to key policymakers.  It is not surprising that the TBTF financial service institutions represent some of the largest donors to both Democrats and Republicans in Congress. Check out the campaign finance numbers here. On the flip side, there is the simple fact that smaller banks tend to charge lower fees, charge lower interest rates on loans, and pay higher rates on deposits than small banks. Size matters, and if the President and Congress fail to address size, then they have learned little from the crisis.

Overall, the Obama administration is proposing little to reduce the size of behemoth banks and financial institutions. Instead of breaking up TBTF institutions, the Obama plan calls for them to be given special status and regulated by the Federal Reserve. Top White House economic adviser and former Federal Reserve Chair Paul Volker says this approach will invariably lead to future crises and bailouts.

Volcker testified that by designating some companies as critical to the broader financial system, and given over to the Federal Reserve to regulate, the plan creates an expectation that those firms  would be guaranteed government backing in tough times. Not only does this pattern of protection “encourage greater risk-taking” and put community and regional banks at a competitive disadvantage, but “ultimately the possibility of further crises, even greater crises, will increase.”

Even former Federal Reserve Chair Alan Greenspan, the man who failed to use his powers to defuse the housing bubble and thus had a major role in creating the current crisis, says the too big to fail problem needs to be addressed.  Greenspan said in October 2009: “If they’re too big to fail, they’re too big. In 1911 we broke up Standard Oil -- so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”

What We Can Do: A New Tool Kit to Cut the TBTF Boys Down to Size

In November of 2009, the European Union was busy breaking up many of their largest financial institutions to recoup taxpayer bailout money and to restore competitiveness in the industry. In the United States, the U.S. Congress was debating the Obama plan which would do little to rein in "too big to fail" institutions. On November 6, 2009, U.S. Senator Bernie Sanders (I-VT) took matters into his own hands and introduced a simple bill that directs the Department of the Treasury to identify too big to fail institutions within 90 days, and take measures to break them up within one year. Sander's bill throws down the gauntlet. It challenges the Treasury Department and the Obama administration to dismantle these institutions so that they no longer pose a threat to the U.S. or global economy. Congress and theTreasury Department have a variety of options to accomplish this goal.

Create New Glass-Steagall Separations for a New Era

In response to the rampant gambling with depositor’s money that led to the stock market crash of 1929, President Roosevelt pushed for new consumer protections including a new law named Glass-Steagall after its primary congressional authors. The 1933 Glass-Steagall Act separated Main Street commercial banks from more risky investment banks, so banks could no longer gamble with the life savings of average Americans. The Act also prevented the merger of banks and insurance firms and created the Federal Depositors Insurance Corporation (FDIC). In other words, Glass-Steagall divided the landscape into the more risky players and the less risky players, then provided government backing for the less risky players.

Glass-Steagall ushered in a new era of remarkable financial stability that lasted almost 60 years until deregulation and rampant corruption generated the Savings and Loan crisis of the late 1980s. In 1999, U.S. Senator Phil Gramm (R-TX) with the backing the Clinton administration led the effort to “modernize” financial regulations and repeal many of the Glass-Steagall separations. At the time, U.S. Senator Byron Dorgan warned that the repeal could be disastrous: “I think we will look back in 10 years’ time and say we should not have done this but we did because we forgot the lessons of the past, and that that which is true in the 1930s is true in 2010.”

The repeal of Glass-Steagall quickly led to the creation of giant financial service institutions that are so complex they are not well understood by their CEOs or their governing boards and risk was difficult to assess and manage. When Citicorp bought Travelers Insurance forming Citigroup, Forbes magazine wrote: "We are at ground zero of one of the most fascinating business and management stories ever to come along."  Today Forbes asks: “Can anyone run Citigroup? We know this banking giant is too big to fail. But is it also too big to manage?” Similarly, former AIG’s CEO Edward Liddy recently wrote in the Washington Post about the financial services and insurance behemoth: “The company's overall structure is too complex, too unwieldy and too opaque for its component businesses to be well-managed as one entity.” 

The elimination of the firewalls between risky investment banking  and boring commercial banking continues to put taxpayers at risk. The FDIC has insured $25 billion of Goldman Sachs’ debt, none of which is in the form of deposits and which it reportedly uses to engage in highly speculative trading in commodities such as oil. If Goldman benefits from its oil speculation, consumers lose in the form of higher gas prices. If Goldman fails in its oil speculation, taxpayers will lose again if they are forced to bailout the firm. This is exactly the sort of mingling of government insurance and speculative investment banking that Glass-Steagall was designed to prevent.

Obama adviser Paul Volker has called for a new Glass-Steagall for a new century. Key to the notion is to exclude from commercial banks risky activities such as ownership or sponsorship of hedge funds and private equity funds. To date however, neither Congress nor President Obama have taken up the idea.

Apply Absolute Size Limits

Absolute limits on size are another useful tool, with the larger institutions broken up into smaller ones that can be allowed to fail without jeopardizing the stability of the financial system.  We already a law in the banking sector, the 1994 Reigel-Neal Act restricts any bank from holding, through mergers, more than 10% of the nation’s bank deposits.  This restriction was ignored in the financial crisis, as Bank of America was allowed to merge with other institutions that likely pushed it over this limit.  It is important that the current limit on size be enforced, and that it be strengthened. 

To ensure that banks are below a “too big to fail” threshold, it would be reasonable to apply a cap of 5 percent of total bank assets since a substantial portion of the funding for large banks does not come through traditional deposits.  Such limits would affect a small number of banks (4-6 banks) given the current levels of concentration in the industry.  Other size limits would be useful as well, such as limits on each institution’s size as a fraction of the overall financial market.

Rein in the Gambling with Significant Capital Requirements

Lawmakers must also ensure that extremely large banks and other financial institutions carry their own risk along with them as they grow, and create certain requirements for capitalization, risk, and tax liabilities that are directly related to size.

Even conservative economist Gary Becker supports progressive capital requirements on institutions based on size. Without adequate capital financial institutions can be subject to an electronic “run on the bank” threatening not just one institution, but in the case of too big to fail banks, potentially the entire financial system. The largest institutions should have a lower capital to asset ratio than small and medium sized firms. While this doesn’t protect against absolute failure, it addresses the problem caused last year and this year where institutions whose failure might threaten economic collapse “had to” ask the government for bailouts. Those that are highly leveraged are constitutionally unstable, as they do not have the capital to cover any major shock to the system.

While the Obama administration has said that capital requirements are a key piece of legislation needed, they have been slow on moving on that front. Currently the biggest banks have a capital requirement of about 4%. Reportedly, the Obama Treasury Department is thinking of raising that to 8%, but many doubt that 8 is enough.  Swiss banks for instance have the highest capital ratios in Europe. Recently, Credit Suisse's Tier 1 ratio stood at 15.5% while UBS's ratio stood at 13.2%. This aspect of financial services reform is critical. It is  important that America lead with the best and not lag with the worst in setting this measure of safety and soundness.

While capital requirements are important, they are not sufficient and must be combined with Glass-Steagall, anti-trust and other reforms. Greenspan warns that capital requirements alone could have only a modest impact. October 2009 Greenspan said: “I don’t think merely raising the fees or capital on large institutions or taxing them is enough. I think they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”

Modernize Anti-trust Policies

Back in the late 1800s early 1900s, “trust busting” was in vogue. Huge firms called trusts or monopolies controlled significant sectors of the economy and the government developed new laws to break them up and foster competition. The focus was on monopolies and “anti-competitive behaviors,” such as price fixing and agreements in restraint of trade.

These laws – such as the 1890 Sherman Act and the 1914 Clayton Act – were constructed in a different era, but are still our primary anti-trust policies today. Much has changed in the American market place.  These old authorities cannot easily address some of the problems we are facing now.  Giant mergers in acquisitions in the financial sector have changed the landscape, but even though the four largest banks hold about 60% of assets in the U.S. banking system, that has not been concentrated enough to attract the attention of the anti-trust officials at the Department of Justice.

This is why some are calling for the development of a new anti-trust law to supplement the earlier laws:  “A new anti-trust policy, one that takes scale into account, would protect against any corporation becoming too big to fail. It would also protect against some of the systematic lobbying, direct and indirect, of Congress by the major companies,” explained one law professor.

 BANKSTER WONK ROOM

• Paul Volcker, House Finacial Services Committee Testimony, September 24, 2009.
• Zephyr Teachout, "Trustbusting 2.0," The Nation, April 7, 2009.