21 August 2012

Douglas J Elliott: Let's relax, and not break up the big banks

Writing for Brookings, Elliott says that anger and frustration have been very poor policy guides for dealing with the financial system. He firmly believes that many of the proposals to restructure banking would damage all of us.

There are a series of proposals to force major changes in the structure of the banking industry, with the intent of either forcing the largest banks to be much smaller or requiring the separation of their deposit-taking and lending activities from their securities market activities... These proposals generally share the underlying assumptions that banks are much bigger and more diverse than they should be and that securities activities are not closely related to the core of what banks ought to be doing.

There are three major problems with these assumptions. First, the many other reforms being put in place render such dramatic changes unnecessary. Second, radical restructuring would sacrifice the substantial benefits these banks provide to economic growth. Third, dramatic structural changes would create serious risks, both in the transitional period and in the longer run.

Dodd-Frank and Basel III already mandate comprehensive increases in bank safety... Adding radical structural change on top of all this is both unnecessary and potentially quite harmful. In particular, there are real economic advantages to having banks that can provide our businesses with a wide range of services, in many different countries, with large enough volumes to minimise costs. There are also many benefits to combining: the direct provision of credit via bank loans; the indirect provision of credit through management of securities offerings in financial markets; market-making activities to keep financial markets liquid; and the offering of risk management tools, including derivatives. Forcing banks to choose which set of services to provide, or to operate at an inefficient scale, would push up the cost of credit and reduce its availability. Our economy is already struggling, in part due to poor credit conditions. Ensuring that burden lasts even longer is not desirable.

Finally, these restructuring proposals represent major, risky experiments. The probability of serious unintended problems is high and the transitional period would be especially fraught with peril. For example, there would be a dramatic shift of business towards financial firms that do not have much experience with the more sophisticated and trickier parts of finance. Unfortunately, there is a long history of medium-sized financial firms blowing up when they expand too rapidly into complex areas, with MF Global as a recent example. It is highly likely that such problems would recur.

It is true that there are risks and problems with a system that includes large banks. However, debate on financial reform often takes as a given that there are only problems and costs, whereas the economic benefits are actually substantial. It is difficult to quantify, but I am confident that the economic benefits of these firms will outweigh their costs in the future under the new regulatory regime. At a minimum, we should certainly be very careful to balance both costs and benefits when considering any of these restructuring proposals.

In that regard, it is worth emphasising that no one has convincingly shown that breaking up the banks would have had a major effect on the financial crisis. Excessive risk-taking, too little bank capital, too little bank liquidity, a housing bubble, government policy that encouraged risk, very low interest rates, general over-optimism, compensation structures that encouraged excessive risk taking, and other underlying factors would have fuelled an equally damaging crisis even if none of the banks had been as large.

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