Big Bank Breakup or Tea Party?

By Apr 4, 2012, 5:03 PM Author's Blog  

We’ve been going back and forth on the economics of too-big-to-fail banks but paying less attention to the politics. The most recent ThinkMarkets broadside on banks is Jerry O’Driscoll’s post on the Federal Reserve Bank of Dallas annual report.

In part of the report, the Dallas Fed’s director of research Harvey Rosenblum argues that the new Dodd-Frank regulations are insufficient to deal with the threat posed by too-big-to-fail banks and therefore these need to be broken into smaller entities. He and the bank’s president, Richard Fisher, made a similar point in a Wall Street Journal column.  Some other Fed officials have espoused the position as well.

Mr. Rosenblum offers an account of how the 2008 financial crisis came about, deftly weaving together various strands that together appear to have led to the catastrophe. Banks that “have grown larger in recent years because of artificial advantages, particularly the widespread belief that government will rescue the creditors of the biggest financial institutions” have a central role in this picture. In the crisis the government did bail out the main players, strengthening the belief.

Dodd-Frank was supposed to provide the alternative to bailouts, namely a way to liquidate insolvent large banks in an orderly fashion so as to minimize disruption in the financial system. Mr. Rosenblum suggests the new liquidation procedures may not be adequate in a major financial crisis if too many banks fail simultaneously, overwhelming the resolution fund financed by fees on banks.

More fundamentally, he questions the credibility of the Dodd-Frank commitment not to bail out failing financial businesses.  “Words on paper only go so far. What matters more is whether bankers and their creditors actually believe Dodd–Frank puts the government out of the financial bailout business,” he writes. If not, both groups may continue to take excessive risk, cause crises and get propped up with taxpayer money.

How can the government make a believable commitment in the light of past extensive bailouts? (And continuing bailouts of government-sponsored mortgage giants Fannie Mae and Freddie Mac.)

This is a political problem that requires a political solution. Obviously, what’s needed is a Tea Party government that is ideologically committed to not bailing out anybody or anything, whether bank, mortgage financer or automaker, big or small. More immediately, each candidate for public office can be asked to pledge to oppose bailouts and held to account if he or she violates the pledge.

Instead, the Federal Reserve’s neo-trustbusters advocate compulsory slimming down of big banks. Mr. Rosenblum acknowledges that this will be difficult and costly, and not only because the banks oppose such policy. Even if they meekly went under the knife, it is not clear how to do the procedure. But, he says, it is worth doing anyway so that this threat to the economy is removed.

Consider what it would involve. In effect, the government would take control of hundreds of billions of dollars worth of property and decide how to dispose of it. This would not only make a mockery of property rights but also create immense opportunities for corruption. Politicians and government bureaucrats would decide who will benefit from the breakup deals and who will lose. Interested parties can offer endless and subtle inducements to get the benefits.

Mr. Rosenblum complains of Dodd-Frank that “The law’s sheer length, breadth and complexity create an obstacle to transparency, which may deepen Main Street’s distrust of Washington and Wall Street…”  The breakup of banks can only further deepen that mistrust.

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