Too Big to Fail is Too Big

Last Thursday, I attended former New York Governor Eliot Spitzer’s timely and stimulating lecture on banking reform. Spitzer exhibited a thorough understanding of the causes of the recent financial crisis and laid out a convincing case for robust regulation of America’s troubled banking system. Among other things, he concluded that the sheer size of American banks was a major contributor to the financial crisis and continues to present a systemic risk to the economy.

After the talk, I found myself wondering how these banks grew so large in the first place. In 1999, Congress passed the Gramm-Leach-Bliley Act, allowing retail banks (which accept deposits and issue personal loans), investment banks (which trade securities and manage corporate acquisitions), and insurers to merge. Subsequently, the pace of bank mergers accelerated, creating gigantic one-stop financial shops. When these banks teetered on the brink last year, Congress, fearing that their collapse would cause economic cataclysm, was forced to bail them out.

The Obama administration’s proposed banking reforms include measures that will indirectly restrict the size of banks. Although this represents a step in the right direction, the president’s economic team has no plans to restore the wall between commercial banks, investment banks, and insurers. This means that the administration is overlooking an underlying cause of systemic bank risk.

Retail banks and investment banks have fundamentally different functions and thus different appetites for risk. Retail banks are low-risk ventures; their deposits are insured by the FDIC. Investment banking is more lucrative but involves greater risk. When these two businesses are placed under the same roof, the result is a severe conflict of interest.

This is the case because the investment banking division can use FDIC-insured funds from the retail-banking division to indirectly finance excessive risk-taking. The retail bank’s customers will not transfer their deposits to a safer institution because they know that the FDIC will compensate them in the event of a bank failure. This moral hazard encourages further mergers between retail and investment banks, which in turn begets more institutions that are “too big to fail.” When excess risk gets a conglomerate bank into trouble, the bill goes to—you guessed it—the taxpayers.

Conglomerate banks that are too big to fail are often too big for executives to manage effectively. As Spitzer pointed out last week, most bank CEOs probably did not want to take on ruinous amounts of risk, but the scale of their operations hindered their oversight. Unsurprisingly, these financial behemoths tend to become unwieldy as they attempt to do too much at once. Consider the case of Citigroup, the product of Citibank’s historic 1998 merger with Travelers, an insurance company. The one-time “financial supermarket” was exposed as a bloated, mismanaged basket case by the financial crisis. Today, Citigroup is selling many of its investment and insurance divisions in an effort to reach a more manageable size and return to profitability.

Finally, conglomerate banks are often large enough to stifle competition. Last month, Alan Greenspan argued that institutions deemed “too big to fail” operate under an implicit subsidy from the government, since they would likely be rescued in a future financial emergency. This allows these banks to borrow more cheaply than their competitors and gain even greater market share. Today, four conglomerate banks (JPMorgan, Citigroup, Wells Fargo, and Bank of America) hold 39 percent of all domestic deposits. Placing this many eggs in four baskets will harm the entire economy should one mega-bank falter in a future downturn.

Paul Volcker, the former Fed chairman, and Mervyn King, the governor of the Bank of England, agree that governments should mandate separation between commercial and investment banks. Volcker argues that President Obama’s “regulate the giants” approach is insufficient, since the market changes faster than regulators can keep up with it. Under Volcker’s plan, commercial banks and investment banks would still be free to flourish—just as separate companies.

Reversing Gramm-Leach-Bliley would help prevent future financial crises before they start, improve the efficiency of America’s banks, and protect taxpayers from future bailouts. Instead of being too big to fail, America’s banks ought to be small enough to succeed.

Anthony P. Dedousis ’11 is an economics concentrator in Leverett House. His column appears on alternate Thursdays.