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Why Congress Should Not Fix 'Too Big to Fail'

Wharton professor David Zaring filed this guest blog post:

At the hearing earlier this week before the Joint Economic Committee, nobody liked banks that were “too big to fail.” Thomas Hoenig decried the “financial megamergers” that led to the problem in the first place. Simon Johnson regretted that “[f]inance became big relative to the economy, largely because of … political decisions” deregulating the banks that should be revisited.
Joseph Stiglitz said that “[t]here are but two solutions: breaking up the institutions or regulating them heavily. For reasons that I will make clear, we need to do both.” Johnson and Hoenig agreed.

What can we do about oversized banks? And are they really so bad?

I’ll consider the solutions first, and then briefly look at the problem. Johnson proposes solving 'Too Big To Fail' through trust-busting. Hoenig suggests conservatorships like the one the Federal Deposit Insurance Corp. imposed on Continental Illinois. I will add leverage caps to the mix, as the G20 suggested that it would support a multinational approach along those lines.

In my view, none of these strategies to shrink the banks requires legislation from Congress, although both Hoenig and Johnson encourage the modernization of those laws. If you think that banks play an outsized role in the political process, or if you think that banking reform legislation will take years to complete, you should be glad to hear this.

It's true that the principal antitrust laws have not been amended in over a century. But that is because antitrust law is a flexible, judge- and prosecutor-made doctrine. In the 1980s, the Department of Justice decided to take a much more hands-off approach to large market share. That decision survived the Reagan administration, and it has been quite popular with economists (and even more popular with law professors).

But there is no reason it could not be revisited now. And if the Justice department wants to focus its attention on banks instead of, say, health care providers, the beauty of those old, broad statutes is that they can be easily interpreted to permit that new enforcement choice.

And the murky powers of conservatorship that the FDIC and Federal Reserve have long had were, if anything, clarified and increased with the 1991 passage of legislation in the aftermath of the S&L crisis. That gave the FDIC and Fed “prompt corrective action” powers to impose conservatorships quickly.

Finally, federal banking regulators have always had the power to devise minimum capital requirements for banks (say, by keeping 8.5 percent of your capital in cash on hand); leverage caps work essentially the same way.

These regulatory fixes are “stroke of a pen” fixes. We might still want a congressional endorsement of them, at least eventually. And if we want to “lock in” bank trust-busting, or require the government to turn to conservatorships before it turns to bailouts, then we will want that legislation immediately. But I don’t think we need it to begin reforming banking now.

But should we reform banking now? Is too big to fail really so bad? Given the regularity of financial panics, I think it probably is. One cautionary note, however. 'Too Big to Fail' doesn’t have to stand for an implicit government guarantee. It could stand for a sensible strategy of scope, economies of scale, and diversification. Investors often want companies to do those things. German, Swiss and Japanese banks grew very big partly, I suspect, because their regulators concluded that their size and sophistication meant that they really couldn’t fail. Those banks are still very big (some of the German and Swiss banks might even be healthy), suggesting that many still appear to believe, unlike the witnesses at the JEC hearing, that size can equal strength.

--David Zaring, assistant professor of legal studies at the Wharton School of Business.

By Sara Goo  |  April 23, 2009; 6:06 AM ET
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'Too Big to Fail' doesn’t have to stand for an implicit government guarantee. It could stand for a sensible strategy of scope, economies of scale, and diversification.

Wasn't that basically Sandy Weill's argument when seeking the repeal of Glass-Steagall? And look where Citi is today.

Posted by: DesolationRow | April 23, 2009 3:54 PM | Report abuse

Stopping "Too Big to Fail" can be done with a single SEC regulation that I call the "MaxCap Rule": Stop upside trading in a company's stock when the company's market capitalization exceeds some universally-adopted threshold value. (I'm thinking $10B, but we can quibble over the exact amount.)

In short, the effect will be to prevent supercorporations from existing at all, let alone being too big to fail.

Think of the AT&T breakup in 1984. A judge decided to break up AT&T into several competitive pieces with individual stock values that, taken as a basket, had the same aggregate value on the day after the breakup as the original AT&T had the day before the breakup. Since then, the investors won, consumers won, and the economy won, all by having more competition in telecommunications as a result of the breakup.

In practice, the MaxCap Rule will cause investors to pressure the management of the company (not a judge or bureaucrat) to break it up into competitive pieces ala AT&T before the MaxCap Rule goes into force.

In other words, the draconian consequences of MaxCap Rule will never happen because investors will pressure management to break up the company into small competitive pieces before they occur.

As for foreign competitors, dening access to American markets to any supercorporation that does not comply with the MaxCap Rule will quickly bring them into compliance, and it will do the world a favor in the process.

Imagine that... One simple SEC regulation together with one simple law that will inspire a purely market-based response that will prevent "Too Big to Fail" from ever occurring again.

Posted by: Jimdotz | April 25, 2009 6:24 PM | Report abuse

You are exactly the type of snake oil salesman we should fear. "No," you say, "we don't need to go changing any LAWS. That would be too...definite. We just need to make some ADJUSTMENTS IN OUR ATTITUDES."

Spoken like one who loves the status quo.

You snake.

Posted by: islvoter | April 25, 2009 7:58 PM | Report abuse

It is good to see WP presenting dissenting views. The 2 concepts repeatedly stated by the "status quo" corner are: 1. the rules are there, apply them if you want change, 2. size matters and bigger is always better. Because these are statements of faith, evidentiary truths will be discounted. It comes down to the strength of the "voices of change" to pursue a public relations campaign which will produce the landslide-size outcry to produce the votes in Congress. Period.

Posted by: thinkingquestioning | April 26, 2009 1:29 PM | Report abuse

TBTF has to stop - it's simply uncivilized. It will require changes in both attitudes and laws, or at the very least rules, but it must start with attitude.

As far as I can tell, there are only a few reasons (all bad) to become "ginormous", POWER and EGO probably the most notable. The power to crush competition or upstarts, the power to grow fatter while doing less. It's an intoxication/addiction issue that is, sadly, an inevitable and far too prevalent aspect of the human condition.

Ultimately breaking this habit will take worldwide clarity and commitment to achieving a cooperative, sustainable manner of operating on this planet that accommodates spiraling population growth and the increasing need to limit resource consumption.

We will never achieve sustainable ways of living balanced with growth while our world is dominated by behemoths with monolithic mentalities.

The mindset "capture" of those passing through the revolving doors between Wall Street and Washington are both a cause and byproduct of the insularity that accompanies monoliths.

This president and his administration are a good start toward breaking up monolithic thinking in our government. Unfortunately, I haven't yet seen it applied quickly or fiercely enough to reverse our financial services industry crisis.

Posted by: kalliek | April 27, 2009 7:53 AM | Report abuse

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