(American Enterprise Institute) -- Arguments that the biggest US banks should be broken into smaller entities because they are too big to fail (TBTF) have recently become more common. Breaking up the biggest banks would obviously have profound consequences for the US economy, but many who support the idea seem not to have given any serious thought to whether the benefits of a breakup exceed the associated costs. Even simpler questions—how small, for example, a bank would have to be before it is no longer considered TBTF—have been ignored. It is somewhat shocking that so many people who should know better have announced their support for the breakup idea without addressing this and other fundamental questions. This does not mean that breaking up the biggest banks is necessarily a bad idea, only that it is a matter of such potential consequence for the US economy that it deserves far more serious thought than it seems to have received thus far from those who favor it.
Key points in this Outlook:
- Although breaking up the largest US banks has attracted significant support from some politicians and commentators, these and other supporters seem to have ignored basic questions that must be answered before a breakup would make sense.
- The idea that any financial institution is “too big to fail” is one that has yet to be definitively proven; what size a bank must before it is not TBTF cannot be known in advance, and the consequences for economic growth of breaking up big banks have not been weighed.
- Calls for breaking up banks are an admission by many supporters of the much-vaunted Dodd-Frank Act that it will not prevent the failure of large financial institutions from causing another financial crisis.
Breaking up the biggest banks is said to have growing support in Congress, but the idea’s supporters—even those who are respected commentators—do not appear to have given it any deep thought. Without any serious discussion, it should come as no surprise that the idea has bipartisan support among the American people. But Martin Baily of Brookings, always levelheaded in his judgments, calls it “nuts.”
Obviously, for the United States to break up its largest banks would be a very consequential step with significant implications for our economy and financial system. Before proceeding, we should have a reasoned debate on the costs and benefits. Instead, what we have had thus far is a surprising chorus of commentators calling for breaking up the banks without seeming to give any attention to the most elementary issues such a step would entail.
This Outlook will lay out some of those issues. These are not technical matters; they are the simple, first-order questions that ought to occur immediately to anyone who supports the idea of breaking up the largest banks—and they have been largely ignored. Ultimately, this is a depressing commentary on how our discourse on important matters of financial regulation and financial structure has descended—in this era of 24/7 media and instant reaction—to the level of slogans and bumper-strip opinionating.
This is not to say that breaking up the largest banks into smaller entities is necessarily a bad idea; I will not argue for or against it in this Outlook, although I will outline some of the more obvious pros and cons. What is clear, however, is that—whatever its long-term benefits— such an action would be highly disruptive to the economy and the financial system. Millions of existing relationships between banks and their individual or company clients would have to be renegotiated; lines of credit that were possible with large banks but not with smaller ones would have to be terminated; employees of large banks engaged in activities that smaller banks would not be able to pursue would have to find other things to do; US companies operating abroad that rely on the assistance of US banks may have to find that assistance, if available at all, from foreign banks. This is only a small list of the revolutionary changes in the US financial system that would have to attend the breakup of the largest US banks.
Moreover, it is reasonably clear—shown by their continuing profitability—that the largest banks are performing valuable financial and other services. The idea of breaking up successful businesses is always troubling unless—as in the case of, say, the old Standard Oil trust —they are substantially harming the economy, an argument that no one has made. Indeed, the argument that the largest banks caused the financial crisis when they stopped lending to one another after the Lehman bankruptcy demonstrates their centrality to the smooth functioning of the global economy.
To be sure, numerous benefits are said to flow from breaking up the biggest banks. Among them are preventing a large bank failure that might bring on another 2008-like financial crisis, assuring that these large and complex institutions can be effectively managed, and reducing the risk-taking and funding advantages that result from their status as too-big-to-fail (TBTF) institutions. But the costs never seem to be taken into account.
Of all these reasons, the most important by far is the possibility that the failure of any of the largest banks might present a danger to the stability of the US financial system—the reason they are said to be TBTF. That, in my view, is the only reason serious enough to warrant the disruption and the risks that would accompany a significant downsizing of the largest banks. Accordingly, I will focus on the TBTF issue and the questions that must be considered—at a minimum—before we proceed with something as consequential as a breakup effort.
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