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Monday, February 13, 2012

Tyler defends big banks

Economist Tyler Cowen disagrees that banks should be broken up, and says so in the New York Times http://www.nytimes.com/2012/02/12/business/making-shareholders-liable-for-big-banks-economic-view.html?_r=2&partner=rss&emc=rss and on his excellent blog, Marginal Revolution. http://marginalrevolution.com/marginalrevolution/2012/02/should-we-break-up-the-large-banks.html

Below, I attempt a refutation of Cowen’s argument, using the part of his NYT article he quotes in his blog.

…the logic of cutting down huge institutions could mean splitting the largest ones into several pieces. Yet banks do not always come in easily divisible parts.

And yet banks do succeed in selling off pieces of themselves to other banks. We’re not talking about randomly dividing banks in half like Solomon slicing a baby. There’s no particular reason banks shouldn’t be allowed to split themselves in some orderly way to maximize shareholder value.

Such a move could amount to eradicating the largest banks rather than splitting them up — and eradication is both politically unlikely and potentially disastrous for the economy. In short, if the resulting parts of a divided bank cannot turn a profit, the split-up may prompt the very bailout it was trying to avoid.

Somewhat unlikely. Remember, these gigantic banks were made up of smaller banks once, and that banks would try to maximize shareholder value in the split.

Another fear is that American money market operations would move to larger foreign banks, which would have a newly found competitive advantage. If a financial problem arose, we would either bail out the foreign banks or rely on a foreign central bank to protect our own interests. Neither option seems appealing.

Another possibility is that by explicitly NOT backing up such operations, American banks would be a safe haven. But Cowen is certainly right that it would be folly to rely on a foreign central bank.

Even if a breakup went well, the incentives for the new, smaller banks would be unhealthy. Those banks could make mistakes or take on bad risks without being punished very much in terms of capitalization or revenue, because of their legally capped size.

But community banks tend to take on less risk overall, if I recall correctly. In part, because they are smart enough to realize that they don’t understand complicated stuff, rather than believing in their hubris they actually do.

Even if they made big mistakes, these banks would probably be pushing on the frontier of maximum allowed growth. Eventually, the competitive process would cease to make these banks tougher or smarter or leaner, and we would just be cultivating another kind of banking system where bad or irresponsible decisions don’t lead to financial failure.

I don’t quite see the mechanism for this. If you become uncompetitive, your profits go down. If you make big mistakes you would fail.

Most important bank failures spring from correlated risks, like the bursting of a real estate bubble, that affect many banks at roughly the same time. Bailing out a large number of smaller failing banks may be easier than bailing out a smaller number of large ones, since it is easier to apply bankruptcy and the procedures of the Federal Deposit Insurance Corporation to the smaller institutions. But that outcome hardly gets rid of bailouts.

1. But who are we bailing out? In general, shareholders of small banks got wiped out, and bank officers lost jobs without cushy severance. Not so large bank shareholders, who suffered losses, but not oblivion, and where the executives got bonuses and by and large do not seem to have doomed their careers.  But certainly it is possible for there to be hits on the FDIC when lots of small financial institutions screw up (the savings and loan fiascos should not be forgotten).

2. But the real devil in the argument is correlated risks. The argument here is that one gigantic bank takes risks, ten banks one-tenth the size (call them decibanks) would take risks that would be correlated.  That’s likely true. But “correlated” isn’t “lockstep”. Banks will tend to take similar actions (correlated) but not identical ones. And one would expect that the dumber the strategy, the less correlation (although since we are dealing  with bankers, that’s not a given).

There is still another problem. The more a bank is legally limited in terms of easily measurable size, the more it may resort to off-balance-sheet activities to make up the difference. “Breaking up big banks” may really mean making these less-transparent bank activities much more important to a bank’s fate.

Yes, banks will try to cheat, like politicians looking for ways around financing laws. Eternal vigilance will be the price of liberty.

My earlier posts on this topic:

http://mikekr.blogspot.com/2009/12/much-much-much-too-big-to-fail.html

http://mikekr.blogspot.com/2009/01/real-bank-robbers.html

http://mikekr.blogspot.com/2008/09/bailout-bullshit.html