Are 19 banks “too big to fail?” Listening to Bloomberg radio, I heard that four banking firms control close to 50 percent of their industry’s assets, that the top 19 control 85 percent, and that the bottom 8000 control 15 per cent. An FDIC report from 2006 described a similar trend.
In a recent econtalk podcast, Gary Stern, past head of the Minneapolis Fed said that “too big to fail” distorts markets. Explaining why, he said that once creditors expect that an institution will be rescued, no matter how risky its behavior, its demand curve shifts lower than it should be for that institution’s securities. The result is “mispricing”. With borrowing less expensive, risky behavior is fueled with funds. Place that fund supply on steroids as before the 2007 panic and you have the potential for a “systemic” calamity. And, going full circle, if systemic calamity is possible, than those big enough to cause it, cannot fail. The challenge is to stop that cycle.
Is the solution smaller financial institutions? As happened during the late 1970s, when banks were prohibited from competing and growing freely, other financial firms took away the banks’ business with a better deal–a higher return and new financial products– for their customers. As a result, the attempt to preserve healthy institutions wound up threatening their survival. Today, we have an international financial community ready to offer “better deals” if we limit our banks. And, we also have an industry where new products, that regulators never imagined, surface daily. Is the solution new regulations? Enforce existing regulations better? Permit failure and let the market take care of itself? Your comments?
The Economic Lesson
Whenever banking is discussed, someone always refers to Glass-Steagall as a benchmark. Passed in 1933, Glass-Steagall is primarily associated with creating the FDIC and requiring banks to spin off their investment banking activities as separate firms. Repealed in 1999, actually, Glass-Steagall had gradually been unraveling since 1980.
Thinking back to Glass Steagall (and related 1930s legislation) which was formally repealed in 1999 (summarized in “It’s Complicated”, my 1/17 blog), there were five problem areas that sound remarkably similar to today’s challenges:
1. Abuse of diversified investment services. Banks had conflicts of interest when they implemented commercial and investment activities.
2. Branch banking: There was concern about banks becoming too large.
3. Interest Rates: Competing for savers through higher interest rates, banks engaged in potentially destructive through high interest rates.
4. Deposit Insurance: Money was fleeing the banks because of lack of confidence.
5. The Power of the Federal Reserve: Which banking authority should be strengthen to prevent future banking abuses?
Today, the White House indicated similar banking industry goals. But Glass-Steagall worked for a 1930s banking environment. Today we have an interconnected world. If US banks are constrained, will businesses easily move to those abroad who are not? As happened during the 1970s here, will disintermediation (my 1/17 blog) resurface?
The Economic Life:
The impact of financial legislation can be unpredictable. Hopefully, legislators will consider opportunity cost more so and populist rage less so when deciding what ultimately will benefit the most people.
Oversimplification concerns me.
Some people are saying we should resuscitate Glass-Steagall. Passed in 1933, the Glass-Steagall Act (Banking Act of 1933) prohibited commercial banks from engaging in investment banking activities and created the FDIC. Also a part of 1933 legislation, Regulation Q established a ceiling on savings account interest rates. Together, Glass-Steagall and Regulation Q created so safe a banking environment that bank failure was virtually impossible. It worked for close to 40 years.
Then though, during the late 1970s, dollars started fleeing the banks because interest rates were considerably higher elsewhere and FDIC insurance was an insufficient incentive for money to remain. Banks are a financial intermediary. When so much money leaves, the phenomenom is called “disintermediation”. Glass-Steagall and Regulation Q created banking restrictions that prevented commercial banks from vigorously competing against non-regulated financial firms. Glass-Steagall and Regulation Q led to disintermediation. Consequently, 1933 banking regulation was gradually phased out.
Soon a dilemma emerged.
With 1930s regulation we had no bank failures. But soon, we would have had few banks because their deposits were diminishing.
With deregulation, money flowed into banks. However, their risky behavior lead to many bank failures. The probable result? Again, many fewer banks.
As the heartbeat of our economy, banks pump our money from savers to borrowers. We need banks for our economy to function.
Figuring out a new regulatory environment is just not going to be simple.
Financial Intermediary: An institution that connects savers with borrowers.
Disintermediation: When a financial institution is unable to connect savers and borrowers.