On Breaking up "Too Big to Fail" Banks

Deutsche Bank in Frankfurt

In 2008, Her Majesty's Government under Prime Minister Gordon Brown and Chancellor of the Exchequer Alistair Darling, opted to bail-out one of the UK's financial giants, the Royal Bank of Scotland (RBS), assuming 82% of it, yet without the power to interfere directly in bank politics. A few days ago, the outgoing Bank of England governor Sir Mervyn King called legislators to break-up RBS as he considers this the best way to recover the bulk of the £45bn used to bail out the bank.

His suggestion comprises of a usual scheme where RBS would be divided into two classes; a the "good" bank which will be sold off to the private sector and a "bad" bank. While he stands by his decision to rescue the bank in '08, he now "realizes" that the process is taking too long; the aforementioned plan could be accomplished within a year. Opposing this view, Frances Coppola states that a careful analysis of the bank's financial statements indicates a much better image than the one 4 years ago. Her view is that such a scheme should have taken place when the bank received state funding back in 2008; now it is too late for that (other sources state that this is what he wanted back then but the Government did not listen).

An alternative view comes from the United States. According to Simone Foxman, the Fed's solution for reducing systemic risk would be extra premiums on banks with assets of more than $50bn on an international basis and forcing banks to retain a portion (the suggestion points at about 5%) of their securitized products. In addition, the banks will be forced to use new risk-weighting standardized procedures as well as hold short-term (2-3 years) Treasuries, with the rationale being the alignment of banks' interests with the ones of the economy in general. In simple words, the banks will have to hold much more capital than they now do. 

As in almost every plan, there are some consequences which are feared:

1. Exposure to long-term debt endangers the bank in the case where the economy is in a recession

2. Foreign banks will be discouraged from operating in the US

3. It is not clear that the reform will lead to smaller banks, or even that the Fed has that goal in mind

Of the above, none is extremely important. #1 will just mean that banks will be making less profits. I highly doubt whether the amount of long-term debt will ever be high enough to allow for credit issues; #2 will not matter much if all countries adopt similar legislation and #3 is more of an economic debate on whether smaller size or increasing returns to scale is better for a firm.

What should worry us most is the sources that will be needed to fulfill these needs, as well as the timing of the decisions. It is not that consultants and lawyers will collect fees from the banks but the fact that with credit already tightened, banks will be forced into consolidation (a fancy word for austerity). This will, in turn, lower the supply of loans in the economy meaning lower investment and lower consumption, things which are never good in a recession.

The issue most important in the regulators' efforts to increase capital is that they do not understand that this should just be the front-line barrier and not the full defense. If another crash, similar to the 2008 one occurs then what this will mean is that banks will probably use ALL of their capital to stay afloat. Then, (in the optimistic scenario that they do not need additional funds to remain in business) they must find a way to replenish that pool of money lost, according to the regulations which the regulators will be strongly enforcing in case of a double-dip recession. What no-one seems to be sharing with us is how these financial institutions will have to find the money to fill their pool again.

Another issue that does not seem to grab the attention of regulators is the fact that the last two crises which nearly broke the system were caused by non-banking institutions: the LTCM investment fund in 1998 and Lehman Brothers in 2008 (which was in the field of investment services as well). Even in the late 2000's crisis what made the authorities intervene was not the imminent collapse of a bank, but of an investment giant: AIG. 

A (simplistic) look at the crisis history will tell us that AIG (and to a much lesser degree Deutsche Bank) was the one issuing Credit Default Swaps (CDS) which protected investors from any fallback in the sub-prime loans market. The banks' investment teams which also invested in sub-prime bonds also used the CDS in order to hedge for their bets. Yet, no regulator had seen that by allowing a firm assume the risk for all possible losses from such products would jeopardize the health of the whole system. Thus, the "too big to fail" title does not apply just for banks but for all kinds of financial institutions, as recent experience has indicated.

Nevertheless, none of the above-mentioned new regulations contributes to safeguarding other financial institutions than the banks. The point of increasing capital requirements until it is unprofitable for banks to operate large balance sheets appears to be what the regulators are trying to promote in the US. According to this article Goldman Sachs was considering to exit the mortgage market if it had to increase its capital by the 260% the law dictated. The fact that they actually stayed in the market after they only had raise their capital by 170% indicates that increased capital requirements may be a substantial reason for a credit drain in the mortgage market. Even worse, it may also make the small banks too small to survive due to increased costs (which are larger as a percentage for smaller banks).

The question which naturally arises when discussing such issues is whether we should care about any other institutions than banks. The fast answer would be no. However, after some more careful consideration we should care for those institutions which can indirectly harm the well-being of banks. If AIG failed, then probably most US firms and banks would have gone down with it by the end of the day. The rest would just survive for another day or two.

The only possible solution for such events is an additional layer of protection in the form of ring-fencing. If investing activities are separated from commercial banking ones then it would make it much less possible for a bank to fail if another institution failed (what is called as the Volcker Rule in the US). Other than this, the question of "too big to fail" remains. Should we break down firms to form smaller and more competitive ones or should just let them be? In addition, when does a bank become un-systemic?

Smaller banks would mean less systemic danger only if they are not interconnected. For example, 20 banks with $100bn each are the same as 5 banks with $400bn each if when one collapses it takes everyone else down with it. What Sir Mervyn King is promoting does not make the bank smaller in the long-run, neither does it make sure that problems of the same kind will not occur again. It merely promotes the idea that the taxpayers' money will not be lost and they will be retrieved from the banks (which is a rather strange notion in a country where printing money is still an option. For details on what what constitutes government debt in an economy Frances Coppola explains this issue thoroughly). What is not mentioned in the proposal is who will the buyer be and how much will the shareholders lose after all. In contrast, having the patience to wait for a few years until the bank repays the state, as was the case with the US, appears to be more reasonable. In addition, it is better for the shareholders as well.

Smaller banks are a good option and so is splitting-up large ones; yet this will not have the results we hope it will if we for do not pay attention to the probability of contagion in extreme events. As Allen&Babus point out, this does not have to mean that banks are less connected, yet it means that they are connected in a better way; one which reduces the risk of a systemic failure. However, as their approach appears to be somewhat too "laissez-faire" these interconnections should be monitored continuously by regulators.

The question that has appeared before in this text now evolves to: how small is un-systemic, and how do we make sure that banks remain too small without having any effects on growth? Even if we are able to control to the interconnections (which is highly doubtful) how can we make sure that the investors have enough credit to go through with their plans and yet the banks are not getting larger? The magic number will be very hard to find. Increasing capital and splitting up banks is not an easy task. In times of recession this proves to be even harder as credit lines drain the economy from a much needed influx of cash. In addition, banks and banking institutions have always been very ingenious in finding legal loopholes, as recent experience with Goldman Sachs and the Volker rule has shown.

What needs to be done remains an enigma. There are many options and many new ideas arise every now and then. Yet, in order to have a clear notion of where we are headed we need to be very specific of both the outcomes and the consequences of each. The economy is extremely fragile at the moment and some moves my prove deleterious to the markets. Merely proposing ideas is not enough; we should look for ones who are both easy to be implemented, providing both low short-run cost and well as high long-run benefit for the economy. Unfortunately, none of the above ideas does this.

P.S. On a similar note, a US Senator has stated that the problem with large banks is that they are "too big to prosecute" or as cleverly dubbed "too big to jail"!