Should we break up big banks?

Ever since the news got out that the U.K. plans to force some of its large, bailout-receiving banks to sell off some operations and become smaller, there's been plenty of speculation on this side of the pond that we might do the same thing.

Richard Fisher, president of the Dallas Federal Reserve Bank, threw down the gauntlet when he said recently that banks considered "too big to fail" should be broken up to make the economy more stable. (Fisher's full speech on the topic is here if you're interested.) A committee in the House of Representatives is pushing for new legislation that would go even further and let the government break up other kinds of companies -- not just banks -- it deemed a threat.

It's a very satisfying idea: Banks that get too big to handle should be forced to downsize. Only trouble is, a lot of economists think it won't address the problem. "The problem is, the really emotionally satisfying things that we could do all create more harm than good," said Douglas Elliott, a fellow at the Brookings Institution, a think tank. On the subject of breaking up banks dubbed too big to fail, Elliot told WalletPop, "It would hurt the economy, which ends up hitting the average person."

How could breaking up big banks hurt us? For starters, some businesses -- think giants like Microsoft and IBM that are based here but whose products are used all over the world -- need banks that can work with them from Seattle to Singapore. Even if we broke up our big banks, the rest of the world isn't going to do the same thing. According to Rob Nichols, president of the Financial Services Forum, an industry trade group, who spoke to WalletPop by phone, keeping American banks small would mean that super-sized European and Asian banks could come in and make our big corporations their customers.

Unfortunately in banking, size doesn't always matter. Treasury Secretary Timothy Geithner once pointed out that the collapse of Bear Stearns and Lehman Brothers had a major impact on the market even though these companies wouldn't have been considered too big to fail.

Reining in banks by size could also give us a false sense of security, said Joseph Mason, a professor of finance at Louisiana State University who doesn't believe smaller banks are necessarily safer. "More regulation isn't the answer," he told us in a recent interview. Doing a better job of closing loopholes that let banks make risky trades and making sure they follow the rules already on the books is a better bet. "Bank failures in the Great Depression showed us that the risks that are going to kill a bank aren't on a regulator's radar screen," he added. In other words, if everybody focused on keeping banks small, some other, as-yet-unforeseen problem could sneak up on us.

Finally, smaller banks would have less ability to lend, especially large amounts to corporations trying to grow. And if companies can't get the money to grow, they can't add jobs. Even with the news that unemployment in November dropped by two-tenths of a percent, we're still in dire need of literally millions of jobs to get the country on the right track again.

Some economists think that a better solution is to let the big banks stay big, but create higher capital requirements; in other words, make banks save more of their money so they have a bigger cushion against losses and won't need Uncle Sam's help. Currently, banks only have to hold onto a tiny percentage of all the money that flows in and out of their branches and computers on a daily basis. Forcing them to keep more of that money instead of lending it out (and earning interest on it) wouldn't be exactly popular among bankers, of course. But think about it: You'd sleep better at night if you knew you had an emergency fund squirreled away somewhere. Don't you want your bank to have that kind of security, too?

Some economists suggest a solution that seems at once simpler and more drastic than breaking up financial institutions: Let a big bank or two fail. Economists such as Peter Wallison of the American Enterprise Institute, who wrote an article in the Wall Street Journal about this, said that AIG was never in danger of bringing down the world's economy when it was bailed out. Sure, some banks would have lost some money, but the entire system wouldn't have come down around our ears.

Other economists are also skeptical of the "too big to fail" idea that one bank could topple the whole economy, like a chain of dominoes. "You have to ask, 'Where's the evidence?'" said Hal Scott, a professor at Harvard University and president and director of the Committee on Capital Markets Regulation. "I think people believe 'too big to fail' is because of interconnectedness. We need a lot more evidence," he told WalletPop, about what kinds of institutions would lose money and how much before classifying a company as too big to fail. Although not a bank, a recent report about the collapse and bailout of AIG showed that the banks thought to be at risk from a ripple effect of the insurer's failure turned out not to be nearly as vulnerable as everyone thought.

If the idea that one bad bank can crash the system is a myth, then letting one bank bite the dust would serve as a powerful lesson, said LSU's Joseph Mason, adding that if a bank is badly managed, it's going to fail eventually anyway. "If the government tries to prop up insolvent institutions," Mason told us, "those institutions will always remain tainted. Without the discipline to maintain sound operations, those institutions will most likely inevitably fail. It merely pushes failure off from yesterday to tomorrow."

That's a sobering though. While the Fed's Fisher is right when he says that too-big-to-fail is bad policy, breaking up banks isn't the silver bullet he (and some member of Congress) are portraying it to be. Beefing up enforcement of existing banking regulations, closing the loopholes and making it clear that the Treasury's not going to come bail them out with a blank check would go a lot further.
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