Opinion

Felix Salmon

Will small banks replicate big banks?

By Felix Salmon
November 12, 2009

Mark Gimein says that we shouldn’t worry too much about the problem of too-big-to-fail, because the alternative to one big bank failing is lots of small banks failing:

What we’ve seen in virtually every crisis is that bank failures and other economic catastrophes are highly correlated, in large part because financial players do not lock themselves up in rooms and gaze at crystal balls. They watch what everyone else is doing and then they do the same thing… The problem of the giant institution that’s an outlier and needs to be bailed out when everyone else is doing fine is one that exists only in theory. What happens in practice is that many banks, large and small, make the same mistakes and fail at the same time. In other words, it tends to be not single banks that need to be bailed out, but big swaths of the whole industry. Breaking up the biggest banks won’t change that.

This misses two key points. The first is that big banks are too interconnected to fail in a way that small banks never are. And the second is that big banks have balance sheets which are so enormous that they can hide all manner of nuclear waste there (as well as in purpose-built off-balance-sheet vehicles) in a way that small banks could never comprehend. Yes, there have been a lot of small bank failures over the course of this crisis. But none of them were a result of those small banks keeping on their own balance sheets a huge quantity of unfunded super-senior tranches of synthetic collateralized debt obligations. You need to be big to be that stupid.

When small banks fail, it’s generally because they make long-dated real-estate loans at high valuations or low interest rates or both. Big banks, by contrast, can fail ways that small banks can never dream of. And when they fail, the consequences for the payments system generally can be disastrous. So yes, breaking up big banks does significantly reduce tail risk in the financial system. No matter what Goldman Sachs says (and they’ve been feeding me the Gimein line for a while now).

Comments
4 comments so far | RSS Comments RSS
 

The current arrangement dealt our nation’s economy a near fatal blow.

There are several issues at stake regarding financial entities that are “too big to fail”.

Does “too big to fail” reduce the danger to economies?

Is “too big to fail” fair in a competitive environment?

Is “too big to fail” logical?

Does “too big to fail” prevent situations where corporate interests can supersede national interest in Congress?

We don’t have to theorize and speculate. The proof is in the pudding.

So why hasn’t the clear and present danger of “too big to fail” been corrected? Perhaps because they are also “too big to be bossed around”.

Congress should have made the arrangements for the demise of “too big to fail” while those corporations were on life support. Now that they have been resuscitated with a transfusion of capital from generations of humanity that haven’t even been born yet, they are regaining their arrogance and swagger.

Posted by Charles Johnson | Report as abusive
 

That’s right Charles, Congress ignored the problem until it became their problem and then finally decided to take “action”.

Unfortunately, the effects of this woeful handling of the banks iss till being felt and will continue being felt for a while yet.

 

Small banks has no meaning. When I was a kid growing up in the Dakotas we had a small bank. The safe rolled around on wheels. It was profoundly unconnected. The banks that make up the top 50 % of the banking system, which my small Dakota bank was not one, are going to be as interconnected as a snarled fishing line whether there are 2 of them or 200 of them.

One can say the top-50% banks would not be equally interconnected if small, but it would be almost impossible that they would not be as interconnected. It the global economy that interconnects them, not their number.

Posted by JCH | Report as abusive
 

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