Should big banks be broken up? A debate
October 25, 2012
The Milken Institute recently hosted a debate between leading economists on whether big banks should be broken up. It followed the recent statements of Sandy Weil, former Chairman and Chief Executive Officer of Citigroup, and Dan Tarullo, a member of the Board of Governors at the Federal Reserve Board, both of whom prominently argued in favor of breaking up the banks. C-SPAN televised the debate several times and streamed it live.

The debate participants were Simon Johnson, professor of Global Economics and Management at the Massachusetts Institute of Technology Sloan School of Management and former chief economist of the IMF; Harvey Rosenblum, executive vice president and director of research at the Federal Reserve Bank of Dallas; Phillip Swagel, a Milken Institute senior fellow, professor of International Economic Policy at the University of Maryland School of Public Policy and former assistant secretary for economic policy at the Treasury Department; and Peter Wallison, Arthur F. Burns fellow in financial policy studies at the American Enterprise Institute and former general counsel of the Treasury Department. Brad Belt, senior managing director of the Milken Institute, moderated the debate.

Belt set the stage for the debate by pointing out that in the United States today, the five largest banks hold more than 50 percent of the total assets in the U.S. banking industry. He added that based on increased bank consolidation since the financial crisis and continued concerns over systemic risk to the economy, some economists have argued that big banks should be broken up to protect American taxpayers. But others have disagreed, arguing that the market can best dictate the appropriate size and structure of banks, and that scale is critical in promoting efficient global credit markets and ensuring the competitiveness of U.S. banks.

Among the takeaways:

Does Size Matter? The panelists were split over whether banks had become too large, complex and interconnected to avoid widespread failure in the face of a crisis and thus should be broken up, or at least certain risky activities be separated from core deposit-taking and lending activities. Rosenblum and Johnson argued that the largest banks are too large and complex to manage and regulate effectively and that they enjoy a significant funding advantage over smaller institutions -- due to the market's view that such institutions would be bailed out in the event of another financial crisis, thereby reinforcing their status as too big to fail. Swagel and Wallison argued that size and scale are necessary to serve global clients and compete against non-U.S. financial institutions. Swagel added that Dodd-Frank's orderly liquidation authority (OLA) provides a mechanism for resolving even the largest institutions. Wallison noted that not enough analysis has occurred to weighing whether the costs of breaking up the banks exceed the benefits.

Panelists on both sides of the debate appeared to agree, however, that a major disconnect regarding the problem of too big to fail is that bank size (measured by either asset size or asset size as a percentage of GDP) alone is not necessarily indicative of whether the institution poses a systemic risk. The need to compete in a globalized economy has created large and incredibly complex, financial institutions. The process of unwinding these institutions -- based on the high volume of bank activity and the unwieldy diversity of regulations across the countries these companies span -- would be a massive regulatory undertaking. Johnson noted that cross-border liquidation is one of the main unaddressed concerns he sees with the OLA, and he said that the OLA did not provide enough, if any, guidance on how to wind down large financial institutions across borders.

Both sides further noted that financial markets have provided interesting insight into the debate over too big to fail. Currently, the share prices of the top five largest and most complex financial institutions are trading at roughly 60 percent of book value, whereas large, more traditional commercial banks are trading at 130 percent of book value. Rosenblum argued that the market is indicating that these large financial institutions are too big to be managed efficiently. However, Swagel countered that the market could also be reflecting the concern of overregulation and uncertainty in the financial industry, not the inefficiencies of large financial institutions.

Source: C-SPAN

Moral Hazard: Rosenblum and Johnson argued that institutionalizing too big to fail incentivizes risky behavior in large financial institutions. However, Swagel argued that the problem of moral hazard could be addressed to the extent that regulators apply the OLA in a manner that imposes losses (a "haircut") on creditors. Both Rosenblum and Johnson were skeptical that OLA would work in practice for the largest institutions, particularly given the lack of clarity as to how it would be applied in cross-border situations. Rosenblum added that government-funded bailouts of large financial institutions, which he called "quasi-nationalization," is far more radical a policy than pursing the deconsolidation of large banks. Johnson further explained that government subsidies of large financial institutions have created lower, more advantageous borrowing costs for these large banks, which otherwise would be higher if dictated by the free market. He added that the economic benefits of the largest financial institutions has not been proven; yet these policies give large banks an unfair advantage over smaller competitors, an advantage that allows them to grow even bigger.

Cost-Benefit Analysis: Wallison countered that regulators need to have a better understanding of the costs and benefits of breaking up the banks before pursuing such a significant change to the structure of banking. (In fact, Swagel, with James Barth and Penny Prabha, recently argued in "Just How Big Is The Too Big To Fail Problem?" that large, complex financial institutions provide scale and lending efficiency, and ultimately give the U.S. a comparative advantage in the increasingly globalized banking industry.) Both Swagel and Wallison said that other polices, including increased capital requirements, help curb risky behavior in the banking industry without requiring a full scale upheaval. Additionally, they stated that providing further restrictions to large financial institutions that are already heavily regulated by the SEC would shift more lending activity to shadow banks, which are far less regulated than accredited institutions, despite their currently holding three times the amount of capital than traditional banks.

Click here to see the full Milken Institute Debate on CSPAN.