Arnold Kling  

I Do Not Like Big Banks and Government

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In NRO, I write,


When large banks have resources, politicians will be tempted to treat them as piƱatas, taking whacks at them in order to extract money to distribute to constituents (see the recent "foreclosure settlement," or the pressure being placed on Freddie Mac and Fannie Mae to write down principal on loans). When large banks get in trouble, politicians will be tempted to bail them out.

Thus, my reaction to the JP Morgan loss was to see the case for breaking up big banks as reinforced. Some day, perhaps I will write a Dr. Seuss version.

See also Mike Konczal (pointer from Mark Thoma.)


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COMMENTS (21 to date)
Kevin L writes:

Steve Horwitz just wrote in response to Krugman that the prohibition on interstate (and therefore large) banks was a major cause of pre-1934 bank failures. So is the instability of a small bank better than the corruptibility of large banks?

Steamelephant writes:

Would like to see how the Dr. Seuss version ends!

Greg G writes:

I am no fan of the big banks and would not grieve to see them broken up but I am still skeptical that this would solve many problems.

First of all, a more fundamental problem is that bankers are like sheep and all tend to do the same thing. When the banking system blew up in the 1930's and the S&Ls blew up later, both caused systemic problems even though none were too big to fail individually.

Secondly, if we can't find one competent management team for a giant bank, how optimistic should we be about finding five or ten competent management teams to replace them?

R Richard Schweitzer writes:

If you have "indigestion," (economic or otherwise) what do you choose not to like?

Why are the "portions" still so large?

What makes banks big; assets held?

Do big banks hold the major portion of surpluses today; or are they held by large enterprises as retained "earnings?"

Why do the percentages of fractional reserve requirements of banks not increase as the volume of assets increase?

Greg G writes:

R.R. Schweitzer's solution of simply sharply increasing reserve requirements for TBTF banks is by far the best idea I have heard on this problem. Risks to the system increase with size so it is entirely fair and logical that reserves should increase proportionally.

Then there would be market incentives for banks to stay smaller and specialize in what they do best. Of course the lobbying power of the big banks is the reason this is unlikely to happen.

diz writes:

It's worth mentioning that "a company that holds a bank" is not "a bank".

rpl writes:
Why do the percentages of fractional reserve requirements of banks not increase as the volume of assets increase?
Did you mean to say "capital requirements" instead of "reserve requirements" in this statement? If not, then I'd be curious to know what your reasoning is. So far as I can see (and I'm admittedly not an expert on banking), banks don't appear to be constrained by reserve requirements at all. Moreover, a bank with inadequate capital is going to be in trouble if it has to write off assets, no matter what its reserve balances were overnight. I just don't see how reserve requirements help anything.
Greg G writes:

Of course you are right rpl. A sliding scale for capital requirements would be more effective and an even better idea.

Eric Falkenstein writes:

I've come around to this solution too. Perhaps some sort of FDIC tax on assets above $100B.

JeffM writes:

As a retired banker (from a bank that neither needed nor accepted, despite strong regulatory pressure to do so, TARP funds), I have several comments.

(1) The loss by JP Morgan is not a large loss relative to its earnings or capital. Banks, like any other kind of firm, are going to have losses from time to time. The world is filled with uncertainty. Banks are in the business of taking (and, at least ideally, managing) risks. If they do their job, they will have losses from time to time. The fact and magnitude of this particular loss do not disturb me.

(2) What IS disturbing is that senior management has admitted to not understanding the risks that were being incurred. This I think is the fundamental argument against very big financial institutions, namely complexity rather than size per se. A very complex organization can have very bright people running its component parts, but no one is bright enough to understand what all those very bright people are doing, and even very bright people err. Small organizations cannot afford to be very complex so senior management, which is the group that has the highest interest in avoiding failure, can understand what is going on.

(3) If Jaime Dimon cannot understand what is going on at JP Morgan, why does anyone think that the Fed or OCC will? Intensified regulation is not the answer. Nor are higher capital standards. Too big to fail is just too big to exist.

(4) The sheep argument is too simple by half. Of course the S&L's took "crazy" risks. By government regulation they had been restricted to a business model that made no sense; once partially released from those restrictions, many were already economically insolvent with every incentive in the world to make bets that had negative expected values but non-zero probabilities of huge gains.

Thomas DeMeo writes:

The problem is the effect of ubiquitous risk management on the stability of the system as a whole, not the size of individual banks.

Greg G writes:

JeffM

I agree with almost everything you wrote above. Most people hate TBTF but how do we get from here to there?

Why don't you think that higher capital standards based on size could provide good incentives for big banks to get smaller and smaller banks to stay smaller?

Jeremy, Alabama writes:

JeffM's #3 is the unanswerable argument against ever more regulatory oversight or Fed involvement.

I am sympathetic to Arnold's dislike of large banks, but I worry about the unintended consequences of a political process that has the power to declare companies to be "too big". It seems to me that government behaves badly with the powers it already has.

Mr. Econotarian writes:

Call me crazy, but I don't trust government to know how to best "break up" big banks.

In our most recent unhappiness, the banks were all following the capital requirements as set up by government ("AAA-rated securities!").

Regulation works best when everybody agrees what is clearly wrong, most participants don't do the wrong thing, and regulation is used to only smack down the small number of participants that do the wrong thing.

Regulation works less good when everybody is "doing the wrong thing" or most participants can't agree on what the "wrong thing" is.

See the drug war or hiring illegal immigrants as regulatory failures.

Our most recent unhappiness was not seen by the majority of government or private participants (yeah I know Ron Paul saw it, that was one guy with no political pull :). Imagining that you can regulate for something pretty much not perceived ahead of time by most people smacks of hubris.

Given the failure of Basel to have picked reasonable capital risks, I'd say that capital regulation should be simplified. Just pick a percent, and forget trying to risk-weight it, you will be wrong (how are those safe European sovereign bonds doing?).

Simple: no bank pays out dividends when you are not meeting your "yellow alert" capital requirements. Then you are resolved if you do not meet your "red alert" capital requirements.

I predict that regardless of Dodd-Frank, Basel 3, etc., and even my mild suggestion, we will still see financial panics in the future!

Glen Smith writes:

Jeremy, Alabama

Funny thing is they got "too big" BECAUSE of the government. For instance, one of the only ways to prevent a business from becoming "too big to fail" is to allow marginal failure (which is often real bad for the individuals involved, especially the rich guys). Now the government is proposing to use similar tools to limit bank size?

R Richard Schweitzer writes:

@rpl

I intentionally used volume of assets.

We have seen the results of "tiers" of "capital" assets.

Familiarity with the Bank Holding Company Act (and how it came into being, in the shape it took) should leave no doubt as to the capacity for an adequate definition of "Bank."

For those unaware of the impacts of fractional reserve banking in displacing "savings" (or until recently surpluses) in funding "investment," notice should be taken of the 25% decline in return on invested assets (compustat) since 1965. (currently now down to around 1.6%)

"Banking" is no longer a purely intermediary function.

JeffM writes:

@ GregG

I have no problem with requiring high capital standards for all banks. Tiering based on too big to fail, however, may have odd consequences.

Bank Small has a 10% capital requirement, but bank Big has a 12% capital requirement because the Fed has deemed it too big to fail. Bank B presumably is farther from the leverage ratio that the market deems profit maximizing ceteris paribus, but the rest are not equal. Bank B has now been officially designated too big to fail and will consequently (almost certainly) have lower funding costs. The trade-off between inferior leverage and superior funding costs may be a net advantage. If it is not, an inferior leverage ratio may encourage creating a riskier portfolio. There are just too many variables in operation to be sanguine that a higher required capital ratio will cause voluntary dissolution.

@ Jeremy

I agree wholeheartedly that a political process that gives discretion to decide which institutions must be broken up and which may continue to exist is open to scary levels of abuse. The only solution I suspect is to have a "bright line" statutory test that does not permit regulatory discretion. Such a test is likely to be somewhat arbitrary, but institutions can manage against it in a way that they cannot with respect to the vagaries of the regulatory process.

@ Mr. Econotarian

I too doubt that regulators will know best how to split up a large complex entity even in terms of some social welfare function (if any such animal exists outside the dreams of some economists). I am quite sure that the regulators will be unlikely to order divestments in a way that preserves value for shareholders and protects creditors. The obvious solution is to require the entity itself to make the divestments required to reduce itself below the statutory threshhold of too big to fail within some reasonable period (say six months).

Jim Glass writes:

JPM lost 0.1% of its assets.

If a person who owned a $200,000 home lost $200 in Vegas, would mass demand arise for govt regulation to keep homeowners out of casinos?

ISTM there is more emotion than reason in all this.

Mark Little writes:

Arnold,

Amen to the NRO article.

Eric Falkenstein,

Yes, but why $100B? As we've recently seen, banking (especially the shadow kind) involves external costs. Why not a highly progressive Pigovian tax on bank assets, across the size scale?

I'd also favor a Tobin tax. A passing acquaintance with the mathematics of dynamical systems suggests that under-damped systems are unstable. Economic arguments for the value of highly liquid financial market are all well and good, but experience suggests that modern financial markets are under-damped. A modest Tobin tax on significant financial transactions is a great damping mechanism.

R Richard Schweitzer writes:

@ Jim Glass

0.1% of the total assets? Though they are on the JPM B/S whose assets are they?

Now, I don't overplay the loss (I own JPM).

But, let's be real - we are talking about assets under management.

Mike Rulle writes:

It is bizarre that the media and some politicians and regulators cannot get enough of the JPM story. I cannot believe how poorly JP Morgan is handling this situation----then again, they are partners with the Feds.

My best guess on losses is they simply got too big in the segment of the market they were trading---so in the zero sum world of derivatives they are trying to be forced out of positions by their counterparts, thus both realizing and increasing their losses---this is what I call a technical error on JPM's part---although relatively small in size.

The financial system as a whole lost zero money---because derivative contracts, unlike the stock market for example, has a winner for every loser. So who cares? Why are we not praising the winners?

The post office is annualizing at about a $12-14 billion loss. Plus there are the Mac Sisters and of course the Feds as a whole which lost 700 times more this year alone then this one trade---not counting that JPM will make $15-20 bill anyway.

What a great changing of the topic. It is absurd.

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