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Breaking Up the Banks – The Great Debate

We certainly live in interesting times, when a National Review writer proposes breaking up the big banks, and Paul Krugman disagrees. First, economist Arnold Kling, in NR:

“In recent decades, the blend of politics and banking created a Washington–Wall Street financial complex in the mortgage market. . . . During this period, Wall Street firms were able to shape the basic beliefs of political figures and regulators, a phenomenon that Brookings Institution scholar Daniel Kaufmann has dubbed ‘cognitive capture.’ Andrew Ross Sorkin’s Too Big to Fail, which describes the response of the Federal Reserve and Treasury to the financial crisis, leaves the distinct impression that senior bankers had much more access to and influence over Washington’s decision makers than did career bureaucrats.”

Then, Krugman’s riposte:

Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

The same would be true today. Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn’t be concentrated on a few big companies — but it would be a bailout all the same. I don’t have any love for financial giants, but I just don’t believe that breaking them up solves the key problem.

So what’s the alternative to breaking up big financial institutions? The answer, I’d argue, is to update and extend old-fashioned bank regulation.

I blockquote, you decide. Krugman falls into the “leverage” camp, who think capital requirements will constrain bank risk, and he wants all traditional regulation, including resolution authority, to extend to the vast “shadow banking” system. Kling says that the political power accumulated by the megabanks means that any regulation of that type won’t reach them, and only breaking them up will restore political and financial balance to the system. He adds that big banks provide no economies of scale or efficiencies that improve the flow of capital.

For his part, Jonathan Chait contends that Kling’s political power argument leads to the conclusion that breaking up the banks is, effectively, a dead letter:

Kling, I’m sure, would reply that regulation won’t work, because the large banks gain so much political power that they can defeat any regulation. I’d respond in turn that that, while this may turn out to be true, they already have so much political power that breaking them up has zero political feasibility. So we’re in a second-best world where it’s regulate, and hope regulation works, or do nothing. My skepticism of Kling’s argument is that, like some principled right-wing arguments that acknowledge climate change, it argues for an ideal solution that lacks any chance of happening, while favoring the status quo over a second-best solution.

This may be true in Kling’s case. However, I’m with James Kwak that breaking up the banks is not a three-month or six-month exercise. It’s a long-term campaign to explain the uselessness and dangerousness of giant banks with massive, entrenched power creating a drag on the economic system. “It takes time to shift public opinion away from the idea that big banks are inherently good. But it’s still the good fight,” Kwak says. I agree.

Anyway, I’m not sure that reining in big bank size is hopelessly lost at the present when one of the Federal Reserve’s regional bank Presidents wants to do it.

In a 45-minute interview this week, Federal Reserve Bank of Kansas City President Thomas M. Hoenig, who’s emerged as one of the few influential voices calling for a fundamental redesign of a broken U.S. financial system:

Lambasted the tilted playing field that benefits Wall Street banks over Main Street banks;
Called the idea that the U.S. needs megabanks to compete globally a “fantasy”;

Said Congress should mandate simple, easily understood and enforceable rules — rather than guidelines — so regulators can restrain financial firms and rein in the financial system;

Prodded the Senate to get tougher on permanently ending Too Big To Fail by enacting laws that would take away much of the discretion currently held by policymakers (who bailed out financial firms when confronted with these decisions in late 2008);

And criticized the Federal Reserve’s ongoing policy to keep the main interest rate near zero because it “guarantee[s] a spread to Wall Street”, enabling unearned profits and “encourag[ing] speculation.”

Hoenig is an inflation hawk and would probably move to turn monetary policy in a more austere direction. But his thoughts on financial regulation are sound, and he’s a voting member on the main policy body of the Fed. Paul Volcker basically argued exactly what Hoenig is arguing, to split certain transactions off and create a wall between commercial and investment banks. And the PRESIDENT adopted the Volcker rule.

I do not believe it’s so clear-cut that the banks cannot be stopped on this one. But even if it was, that’s not a good enough reason not to pursue every avenue to bring stability to the financial system. That includes the kind of leverage limits and resolution authority Krugman favors, consumer financial protection like Elizabeth Warren has proposed, AND actions that would truly end too big to fail.

UPDATE: Mike Konczal has a really smart take on this.

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David Dayen

David Dayen