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Banks’ size is greater threat than complexity

Senators from both sides of the political divide are displaying an encouraging resolve to break up the country’s biggest banks. Unfortunately, they’re focusing too much on the complexity of big bank operations and ignoring the greater threat entailed in their enormous size.

Earlier this month, a bipartisan group of senators, led by Democrat Elizabeth Warren and Republican John McCain, introduced a piece of legislation known as the “21st Century Glass Steagall Act.” In just 30 pages, the legislation re-separates federally insured commercial banking from all other types of diversified financial activities, including insurance, securities activities, derivatives operations and hedge-fund and private-equity investments. It is aimed squarely at our too-big-to-fail banks, just five of which command about two-thirds of all the industry’s assets.

The bill represents a welcome re-awakening from the nightmare of the Dodd-Frank financial reform act, which attempted — through thousands of pages of rules — to contain the risk of megabanks without reducing their size. Three years after the passage of Dodd-Frank, about 60 percent of the rules have yet to be completed. They include the so-called Volcker rule, which is supposed to separate trading undertaken to serve bank customers from “proprietary trading,” done purely to generate profits for the bank. Regulators have also granted banks a two-year reprieve from a requirement that they push out derivatives trading into separate uninsured subsidiaries.

Falls Harder

The result: Our five largest banks are significantly bigger than at the time of the crisis. Not only is such size dangerous — a $2.5 trillion bank falls harder than a half-trillion-dollar bank — but such concentration and industry domination is anti-competitive. Just four banks, for example, control 90 percent of all U.S. banks’ derivatives activities.

Senators Warren and McCain are right to focus on mitigating the threat posed by such giant, systemically important institutions. But by resurrecting only the well-known separation construct of the original Glass Steagall Act, their legislation would do only half the job — indeed, it would overdo it.

Today, size matters more than separation. Although highly diversified financial activity is undeniably risky at the scale of today’s megabanks, some degree of functional diversity is desirable at much smaller scale. Diversification of all types is an element of risk reduction. What we need is size diversification — many more smaller banks, whether moderately specialized or moderately diversified, carrying out the functions now concentrated in a handful of banking behemoths.

One of the most powerful provisions of the original Glass Steagall Act was Section 23, which effectively imposed a size limit by mandating that federally insured commercial banks obey the banking laws of their headquarters state. All states were protectionist, prohibiting branching — and, thus, deposit gathering — by out-of-state banks. No bank could gather enough deposits within one state to become too big — with the partial exception of a few so-called money-center banks, which amassed significant amounts of uninsured institutional deposits and short-term debt borrowed in the money markets.

Of course, there’s no going back to yesteryear’s state-based size limits, so we have no choice but to impose a set of numerical size limits. These could entail either inflation-adjusted dollar ceilings or limits on market share. There should be constraints on assets and insured deposits, as well as on short-term money-market borrowing as a percent of insured deposits. Federal Reserve Board Governor Daniel Tarullo has identified excessive reliance on short-term borrowing as a particular threat to the safety and soundness of individual megabanks and to the financial system as a whole.

Breaking Up

How to go about cutting the big banks down to size? The first step must be a break-up, because forcing our existing institutions to shrink would lead to a lending squeeze with negative economy-wide consequences. After the break-up, size ceilings can accomplish the task without constraining lending.

Breaking up is easy to do. Virtually all types of megabank assets and operations can be sold in whole or in part. Indeed, the big banks could even be split up proportionally, creating mirror-image institutions to be spun off to current stockholders. There’s no need to give the banks five years to comply, as the Senate legislation does. The original Glass Steagall Act took effect in one year.

Our forebears in 1933 had the courage to break up their big banks, including the House of Morgan, the banking empire of the most powerful banker of the era, John Pierpont Morgan Jr. We must summon the same courage today, most prominently in the case of the present-day goliath that bears his name.

As appeared in Bloomberg on July 21, 2013.


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