Want To Break Up The Banks? Be Very Careful What You Wish For Jul 14th 2013, 10:00
President George W. Bush stands with Federal Reserve Chairman Ben Bernanke, left, SEC Chairman Chris Cox, right, and Treasury Secretary Hank Paulson as he delivers a statement on the economy Friday, Sept. 19, 2008, in the Rose Garden of the White House. (Photo credit: Wikipedia)
A popular refrain on the left AND right ever since the financial crisis* is that to ensure nothing like it happens again, the banks must be broken up. Explicit here is that if no bank is too large, no one entity can 'threaten the financial system' if calamity strikes. They also presume that smaller banks mean no more bailouts. Both are nice thoughts, yet totally divorced from reality.
For one, U.S. banks aren't all that large. In terms of assets, there are only two among the world's ten biggest (JP Morgan Chase and Bank of America Bank of America), and they rank 9th and 10th. The rest of the largest banks are foreign owned, so if you believe the 'Mother of All Great Depression,' 'Crush the Financial System' narrative as Ben Bernanke and the break-up-the-banks crowd do, sorry, but 'systemic risk' has a foreign address.
Never explained – at least very well – is why big is bad. In most other industries (particularly lightly regulated ones) a company grows large mainly because it's serving the needs of the marketplace well. Banking, on the other hand, is a highly regulated industry, so it's fair to assume that size at least to some degree is a function of political pull. Of course that's one of many reasons why banks shouldn't be broken up, as will be explained further along.
But first, lost on the break-up-the-banks crowd are notions of return-on-equity, profit margins, earnings, and other things that investors care deeply about. No investors, and no companies. Simple as that.
Applied to banks, if you break them up you're almost by definition reducing their profit margins. Boost their capital requirements? To do so is to similarly reduce their ability to reward investors with high returns, at which point investment will flow to unregulated (this is a good thing) financial institutions, not to mention larger foreign banks not so encumbered.
It must be stressed that banks are large because economies of scale (geographical diversification is said to be another positive factor) make it smart to grow. If by government decree banks are broken up, it's only a matter of time before they – through acquisitions – start swallowing each other once again in order to achieve the economies of scale, profitability, and other forms of return craved by investors.
To the above some will surely say that regulations will 'ensure' that banks will never grow large again. Doubtful, but even if it's true, implicit in such a suggestion is that by regulatory decree banking will be an unprofitable, talent-free sector. Sorry, but if you limit the ability of businesses to grow, along with their profitability, you're by definition limiting how much they can pay their employees. If the pay is low, the talent will go elsewhere. Banks as the new GMs and Chryslers? It's not very far-fetched if the break-up-the-banks crowd gets its way.
Talent-free banks acting as utilities might appeal to some. They would even appeal to me in a certain sense. Bernanke et al told us that absent the bailouts of the banks that credit would dry up on the way to a staggering recession, but the real truth is that most finance and lending has long occurred outside the banking system. In that case, if politicians want the banking sector to resemble the U.S. automobile industry, fine.
The best financial minds will depart the banks in even greater numbers than they are, as will investment and deposits. Banks will become even more politicized in their lending because lacking talent and serious investment, they'll only exist at the pleasure of politicians.
To the break-up-the-bank gang, seemingly all of this is ok because they want to put bailouts in the rear-view mirror. That's fine, this writer does too, but they're dreaming if they think bailouts will end simply because banks will have been broken up.
The reason for this is basic, though perhaps contrary to what most are used to reading. Put simply, banks aren't heavily regulated because they're not politically connected, in truth they're heavily regulated precisely because they are politically connected. And because they are, connected banks will either skirt the rules on size or they'll shrink their way to market irrelevancy; their ongoing existence a function of their ability to please their political masters.
In short, shrunken banks will face profit pressures for being made artificially small, for being less profitable they'll be more reliant on their political angels, and when they inevitably fail due to smaller margins, politicized loans, and talentless management, their ties to the political class will ensure their ongoing survival. If government can force banks into lower margins, rest assured that it will pay when these politically potent entities start to implode. Conversely, if the feds look the other way as the banks merge again in order to compete, any failures will fall at the doorstep of a federal government that allowed all the M&A activity. Hello bailouts yet again.
What's comical about all this is how unnecessary it all is. Implicit in the break-up-the-banks mentality is that if a financial institution grows too large that its failure will send the economy into a multi-decade funk. The very supposition would be very funny if it weren't so sad, and if it didn't carry with it such dire, economy-suffocating implications. Many people in power do believe this narrative, including our present Fed Chairman. As Bernanke put it to then House Speaker Nancy Pelosi about propping up the banks back in 2008, ""if we don't act in a big way, you can expect another great depression, and this time it is going to be far, far worse."
Back to reality, for those fearful of one, ten or 100 financial institutions' failures crushing the economy for decades, simply Google Google post-WWII photos of Japan and Germany. Both countries were literally reduced to rubble during the war, but within a few years of its end, and bolstered by falling tax rates alongside stable money, both country economies ascended to some of the world's largest in fairly short order.
Scott Foresman Science
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